TEST BANK for Ethical Obligations and Decision-Making in Accounting: Text and Cases, 6th Edition By

Chapter 1: Ethical Reasoning: Implications for Accounting MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

1) What is the common characteristic of Aristotle's virtues and ethical standards for CPAs? A) truthfulness B) integrity C) loyalty D) due care

2) Jane finds a material misstatement while auditing a client's accounts receivables. Her senior tells her to ignore the misstatement so that the client does not get upset. Jane wants to be viewed as a team player in order to advance in the firm, so Jane follows her senior's instructions and ignores the misstatement. Which ethical theory did Jane use to make her decision?

A) egoism B) justice C) virtue ethics D) utilitarianism

3)

Which of the following situations would be considered ethical?

A) The cashier at Wal-Mart gives you $5 more than you were supposed to receive and you don't do anything about it.

B) You accidentally back into a car at Wal-Mart and leave your information for them to call.

C) You receive fake $20 bills and use them in a store while knowing they are fake.

D) You find a phone in a restaurant and keep it.

4) Which of the following characteristics does not describe the importance of integrity in decision making?

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A) Acting out of moral principle B) Being loyal to one's superior C) Having the courage to do the right thing D) Not subordinating professional judgment to others

5) Which of the following characteristics does not describe the behavior of Cynthia Cooper in the WorldCom fraud?

A) persistence B) competence C) integrity D) conformity

6)

The ancient Greeks thought of the virtues as characteristics of behavior that A) could lead to a good life.

B) make up the "six pillars of character".

C) support the rights theory.

D) rationalize unethical actions.

7) Which of the following elements does not make up an integral part of what is meant by "ethics"?

A) accepted standards of behavior B) knowing the difference between right and wrong C) always following the law D) the moral point of view

8)

Ethical relativism can best be described as

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A) a point of view that morality is relative to the norms of one's culture.

B) a concept that holds that integrity should be maintained in the face of pressure by others.

C) an ethical reasoning method that holds one should always act out of self-interest.

D) an ethical reasoning method that holds one should always consider the effect of one's actions on others.

9)

Which of the following is not a pillar of character according to the Josephson Institute?

A) caring B) citizenship C) respect D) judgmental

10) Which of the following is not an element of trustworthiness according to the Six Pillars of Character?

A) reliability B) loyalty C) fairness D) honesty

11) An accountant who blows the whistle on financial wrongdoing by his/her employer by going outside the entity violates A) the due care principle.

B) confidentiality.

C) one's reliability obligation.

D) public interest obligation.

12)

Cancel culture results in each of the following except:

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A) manifests itself through intolerance of others with a point of view that diverges from group norms B) exhibits a lack of respect for something someone said or did such as making offensive comments toward another C) its goal is to embarrass someone in their community D) enables a greater understanding and mutual compassion for one another

13) The 2019 annual poll on civility in society by Weber Shandwick continues to show that a vast majority of Americans identify incivility as a problem in society. The consequences of incivility include all of the following except A) people feeling safer in public places.

B) cyberbullying.

C) harassment and unfair treatment of certain groups of people.

D) feelings of isolation and loneliness.

14)

Respect is an important character of behavior because A) it entails a loyalty obligation to one's superior.

B) it enables one to perform professional services competently.

C) it is critical to maintaining one's integrity.

D) it encompasses attributes of how we should treat others.

15)

Responsibility goes hand in hand with A) respect.

B) loyalty.

C) courage.

D) accountability.

16)

Treating others fairly encompasses treating them

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A) equally, impartially, and responsibly.

B) equally, responsibly, and openly.

C) impartially, openly, and diligently.

D) equally, impartially, and openly.

17)

Which of the following characteristics is not part of behaving with empathy?

A) being loyal to one's friends B) being understanding of one's friends C) being sensitive to the feelings of one's friends D) being caring about one's friends

18)

If one's reputation is tainted, it may create a A) conflict of interest.

B) loss of independence.

C) lack of trust.

D) loss of objectivity.

19)

The Public Interest Principle in the AICPA Code of Professional Conduct recognizes A) the importance of integrity in decision making.

B) the importance of loyalty to one's superior.

C) the importance of whistleblowing when financial wrongdoing exists.

D) the importance of maintaining confidentiality.

20)

Objectivity requires that a CPA should A) maintain a mental attitude of intellectual honesty and independence.

B) maintain a mental attitude of intellectual honesty and impartiality.

C) act in accordance with the best interests of one's client.

D) act in accordance with the best interests of one's employer.

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21)

The Independence Principle in the AICPA Code applies to A) all accountants and auditors.

B) all CPAs regardless of professional services.

C) all CPAs who render attestation services.

D) all members of the audit committee.

22)

A CPA would violate the Due Care Principle if he/she

A) undertook a professional engagement without having the requisite background, knowledge, and experience.

B) specialized in the industry of the client, even offering training classes for other accounting firms on the industry.

C) worked for an accounting firm that used two external partner reviews on high risk audits or clients.

D) performed tax services for an audit client with audit committee approval.

23) Aristotle believed that blank always preceded the choice of action. Aristotle is quoted as believing, “We are what we repeatedly do. Therefore, excellence is not an act. It is a blank.”

A) virtue B) choice C) habit D) trait

24) The method of ethical reasoning that deals with making decisions after considering the interests of others is A) egoism.

B) enlightened Egoism.

C) utilitarianism.

D) Rights Theory.

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25)

The method of ethical reasoning that evaluates actions in terms of harms and benefits is A) act utilitarianism.

B) rights theory.

C) justice.

D) virtue.

26) The method of ethical reasoning that requires selecting the correct moral rule that produces the greatest benefits over harms is A) act utilitarianism.

B) rule utilitarianism.

C) rights theory.

D) justice.

27)

Which of the following elements is not an integral part of Rights Theory?

A) act based on the consequences of one's actions on others B) treat people as an end and not merely as a means to an end C) act in a way you would want others to act in similar situations D) act in a way that is universally accepted

28) The ethical reasoning method that is based on treating equals, equally and unequals, unequally is A) enlightened egoism.

B) act utilitarianism.

C) justice.

D) virtue.

29)

Teleology deals with

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A) consequences of actions.

B) fairness to others.

C) respecting the rights of others.

D) following prescribed virtue characteristics.

30)

Deontology deals with A) rights of others and duties toward them.

B) consequences of actions.

C) following prescribed virtue characteristics.

D) following the law as an element of ethical behavior.

31)

The biggest problem in implementing a utilitarian approach to decision making is A) the interests of others may be subservient to self-interests.

B) it fails to consider the interests of others.

C) it can be difficult to weigh all the consequences of actions.

D) it relies on moral absolutes.

32)

The biggest problem in implementing a rights approach to decision making is A) the interests of others may be subservient to self-interests.

B) it is difficult to weigh harms and benefits.

C) it relies on moral absolutes.

D) it can be difficult to determine criteria to distinguish equals from unequal claims.

33)

The biggest problem in applying virtue theory to decision making is

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A) it can be difficult to identify virtues.

B) it relies on moral absolutes in decision making.

C) it can be difficult to determine virtues to distinguish equals from unequal claims in decision making.

D) conflicts between virtues may make decision making more difficult.

34) The credibility standard in the Statement of Ethical Professional Practice of the IMA requires that an accounting professional do all of the following except A) communicate information fairly and objectively.

B) disclose all relevant information that might affect the intended user's understanding of the reports, analyses, or recommendations.

C) disclose delays or deficiencies in information, timeliness, processing or internal controls in conformance with organization policy and the law.

D) exclude professional limitations or other constraints that would preclude responsible judgment or successful performance of an activity.

35) Under the IMA's standards of ethical practice, an accounting professional can consider informing authorities or individuals not employed by the organization when an ethical dilemma occurs about an accounting or financial reporting matter that remains unresolved if he/she A) believes there is a clear violation of the law.

B) contacts his/her immediate superior who says to forget about the matter.

C) informs the external auditors who tell him/her to inform the appropriate authorities.

D) believes there has been an ethical violation.

36) Eddie paid an $8 restaurant check with a $10 bill. The waitress gave him $12 back. The most ethical action for Eddie is to A) keep the extra $10.

B) inform the waitress of her overpayment.

C) inform the manager of the restaurant of the overpayment.

D) leave a larger tip for the waitress.

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37) Sally is the only student from a foreign country in an Auditing class. On the day of the midterm exam, Sally asks the teacher whether she could use a dictionary to translate English words to her native tongue so she can better understand the questions. What do you think the instructor should do if she follows the ethical principle of justice?

A) allow Sally to use the dictionary since she is at a disadvantage B) not allow Sally to use the dictionary because she should know enough English to get by C) allow the other students to bring in some tool to give them an advantage D) make an easier version of the exam just for Sally

38) George is in the middle of a high stakes poker game when he notices what he thinks is cheating by another player. It appears to George that this player took a card from his lap and switched it with a card that he was dealt. If George is a utilitarian thinker, he should A) accuse the alleged cheater of cheating in front of all the other players.

B) consider what might happen if he accuses the player of cheating and he is wrong.

C) speak to the alleged cheater during a regularly scheduled break and tell him not to do it again.

D) forget about the whole matter.

39) Janice is a staff accountant in the accounting firm of Obama and Biden. She is assigned to the audit of HealthCare Associates. On the very first day Janice noticed that the accounting manager of the client took money out of the petty cash fund and put it in his pocket. The best action for Janice to take is A) ignore the situation because Janice doesn't know why the manager pocketed the money.

B) inform her immediate supervisor of what she observed.

C) tell another staff accountant who is a friend and ask for her advice.

D) tell the superior of the accounting manager what she has observed.

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40) Kelly is the controller of a small company. One day the CFO comes in and tells her to lower the estimate of uncollectible accounts receivable. Kelly insists her numbers are correct as is. The CFO tells her it will mean her job at the company if she doesn't go along with the smaller estimate. The primary virtue that would enable Kelly to resist the pressure to manipulate the number is A) loyalty.

B) integrity.

C) caring.

D) objectivity.

41) Jason is the fastest worker on the audit of a company for the firm Zits LLP. Other Zits workers take twice as long to complete the equivalent amount of work as Jason. One day Jason is approached by the other workers and is asked to slow down. "You are exceeding the time budget for the audit and making the rest of us look bad," said one staff member. From an organizational, ethical point of view, the best thing for Jason to do is A) tell the other staff members that he will use the time he saves on his budget to help them to meet their budget by picking up their slack.

B) approach the supervisor to discuss the pressure of fellow staff to slow down on doing audit work.

C) explain to the other staff members that he works diligently and they should do the same.

D) tell the other staff members to mind their own business.

42) Steve is deep in debt due to a gambling problem. He is the bookkeeper for a familyowned business, Cal Poly Greenery. The company has only three employees—Steve, the husband, and the wife. All three have been friends for many years. One day the loan shark who lent Steve $20,000 comes knocking at his door asking for repayment of the loan. Steve convinces the loan shark to give him another day. The following day Steve writes a check on the company's books to himself for $20,000. Since he reconciles the bank accounts and prepares the financial statements, Steve knows it's unlikely the owners will ever know about what he has done. From an ethical perspective, Steve has

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A) violated the trust placed in him by the owners.

B) risked his reputation if the loan shark finds out.

C) risked his ability to continue working for Cal Poly Greenery.

D) all of these choices are correct.

43) Ty is a rising star at Texas State Country & Western Stores. He is the controller of the company. His wife, Rosie, is the lead auditor of the CPA firm that examines Country & Western's financial statements and issues an audit opinion. Given the nature of the relationships, Rosie would violate what ethical standard if she is allowed to conduct the audit?

A) integrity B) due care C) independence D) responsibility

44)

The most important duty of public accounting is to the A) Securities Exchange Commission.

B) current stockholders.

C) management.

D) investing public.

45)

The best restatement of Kant's categorical imperative is

A) do to others as you would have everyone do unto you.

B) consider others’ needs before you act.

C) that those with a smaller stake should have a smaller say compared to those with a bigger stake.

D) that the ends justifies the means.

46)

What is the one virtue that people should want in a boss, to trust a boss?

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A) diligence B) commitment C) honesty D) sense of humor

47) Virtue ethics emphasizes development of good habits of character. What should be the greatest reward of practicing good habits of character, according to MacIntyre?

A) external rewards B) loyalty from others C) internal rewards D) authority of rules

48) Michael Josephson, founder of the Josephson Institute of Ethics, is credited for developing A) Book of virtues.

B) Care and response orientation.

C) Six Pillars of Character.

D) Rights theory.

49)

Internal rewards of accounting practice include A) wealth and prestige.

B) success and power.

C) integrity and excellence.

D) achievement and notoriety.

50)

Utilitarian philosophers are divided into two types: act utilitarian and

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A) rule utilitarian.

B) egoistic utilitarian.

C) ethical utilitarian.

D) beneficial utilitarian.

51)

Greatest good for the greatest number of people is the theory of A) rights.

B) deontology.

C) utilitarianism.

D) justice.

52)

The motive of "duty" is most associated with A) egoism.

B) deontology.

C) utilitarianism.

D) justice.

53)

Virtue ethics is A) doing what is right.

B) one's duty to act in a socially acceptable manner.

C) one's ability to meet or exceed their potential.

D) what one ought to do when presented with an ethical dilemma.

54) Bob is being pressured by his superior to go along with improper accounting and told he is expected to be a team player. Which of the following statements best characterizes those expectations?

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A) independence B) confidentiality C) loyalty D) utilitarianism

55) When making a donation at the local Goodwill, Martha tells the clerk that her old computer is in perfect working order when she knows it is not, just so she can deduct more on her taxes. Which theory best describes Martha's behavior?

A) utilitarianism B) deontology C) egoism D) justice

56) Decisions that are made based on the underlying circumstances of a particular matter can be best characterized by A) ethical Collectivism.

B) situational ethics.

C) ethical relativism.

D) judgmental Individualism.

57) by

Decisions that are made based on the underlying cultural factors can be best characterized

A) ethical collectivism.

B) situational ethics.

C) ethical relativism.

D) judgmental Individualism.

58)

When applying Utilitarianism to judge actions, what is the only thing that matters?

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A) motives B) fairness C) consequences D) rights

59) Assume you are taking an exam and you clearly see that your friend is cheating. Your professor does not notice it. What is the most appropriate action for you to take if you are an ethical person?

A) pretend not to notice it B) discuss the matter with your friend after the exam C) also cheat the exam because your friend does D) send a text message to your friend and tell them to stop cheating

60) Your manager asks you to "cook the books" to support a loan application at the local bank. The manager insists it is a one-time request. What should you do?

A) go along with the manager's request B) talk to others in the company to determine how they handled such situations C) refuse to go along with the request D) inform the audit committee

61) A difficult choice between two moral principles that are in conflict with one another is known as a/an A) ethical relativism.

B) situational ethics.

C) ethical dilemma.

D) conflict ethics.

62)

The relationship between legal and ethical can best be expressed as

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A) always follow the law regardless of consequences for others.

B) ethical behavior requires less than legal behavior.

C) legal and ethical are the same thing.

D) ethical behavior requires us to do more than required by the law and less than the law allows.

63)

When an employee is given a job evaluation, he has a right to expect A) fair evaluations.

B) caring and empathy on the part of the evaluator.

C) 360 degree evaluations from everyone in the firm.

D) evaluations of technical, not personal skills.

64) A danger of situational ethics is that it can be used to rationalize a wrong-doing. Such rationalizations may be seen in all of the following examples except A) cheating at the University of North Carolina.

B) hiding Anne Frank’s family to escape Nazi terror.

C) betty Vinson's actions at WorldCom. D) david Walker’s actions at the Government Accountability Office.

65) Individuals that ignore the moral point of view and take advantage of others in an effort to meet their own short-term objectives can be classified as A) deontologists.

B) relativists.

C) egoists.

D) utilitarians.

66)

Civility requires all but the following

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A) restraint.

B) politeness.

C) respect.

D) disregard.

67)

Which of the following is true of the relationship between civility and ethics?

A) One can be both ethical and uncivil.

B) One can be both civil and unethical.

C) One can use others, be a bully and be ethical.

D) One can have empathy and caring for others and be uncivil toward them.

68) Which of the following is not a likely rationalization a student might use to justify cheating on an exam?

A) ethical relativism B) situational ethics C) cultural conditioning D) fair treatment

69)

The cultural value of Individualism reflects A) the degree a society reinforces individual or collective achievement.

B) tolerance for uncertainty and ambiguity in society.

C) the degree of equality between people in a society.

D) whether a society has a long-term or short-term orientation.

70)

The basic and fundamental beliefs that guide or motivate attitudes or actions are called

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A) relativism.

B) egoism.

C) morals.

D) values.

71) In the University of North Carolina cheating scandal case, using ethical reasoning who is at fault for the situation?

A) the professor B) the academic staff C) students who cheated D) All of these choices are correct.

72)

In the Giles and Regas case, the primary ethical issue can be stated as A) whether a subordinate should blow the whistle on a superior who has violated ethical

policy.

B) whether two staff members of the same rank should be allowed to date.

C) whether a superior should become involved in a dating relationship with a subordinate.

D) whether a student should renege on the acceptance of an offer from one firm after receiving an offer from a second firm.

73)

In the Operation Varsity Blues case, the primary ethical issue in the case is A) falsification of financial statements.

B) bribes for favored treatment.

C) the lack of independence of the audit team.

D) an inappropriate relationship between a supervisor and subordinate.

74)

In the Lone Star School District case, the auditors were mostly concerned about

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A) the behavior of a staff member toward client personnel.

B) the falsification of the financial statements.

C) the lack of independence of the audit team.

D) the lack of documentation for travel and entertainment expenses.

75)

The main issue in the Unintended Consequences case is

A) should the student who accepted an offer from one CPA firm back off from that promise in order to accept the offer of another firm deemed more preferable to the student.

B) should Regas back off from the dating relationship she developed with Giles.

C) should the CPA firm renege on its offer of employment to a student after realizing it made one offer too many to student candidates for staff positions.

D) should Tybell quit the firm because of conflicts with his superiors.

76) In the Capitalization versus Expensing case, the main ethical issue is whether Gloria Hernandez should A) capitalize or expense $1 million of expenditures.

B) report her superiors' actions to the CEO. C) talk to the audit committee about the pressure imposed by her supervisor.

D) become a whistle blower.

77) to

Kevin Lowe's ethical dilemma in the Eating Time case can best be described as whether

A) date another staff member of the CPA firm.

B) inform his supervisor about a lack of diligence of other staff accountants.

C) quit his job because he can't meet the firm's expected quality of work.

D) devote time on an audit and not charge it to the job.

78) In the Section 179 Deduction for Equipment Purchases case, the primary ethical issue can be stated as

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A) whether an accountant should claim a higher deduction than allowed by law.

B) whether an accountant should claim lack of diligence of other staff accountants.

C) whether an accountant should claim inflated expenses on the company tax return.

D) whether an accountant should claim lack of competence by other staff accountants.

79) In the Cleveland Custom Cabinets case, the owner of the company thought it was all right to manipulate the financial statement numbers primarily because A) he wanted to improve earnings to increase the share price of company stock.

B) the treatment recommended by the owner for estimating overhead conformed to GAAP. C) he was the sole owner of the company and controlled the board of directors.

D) he got approval from the auditors.

80)

In the Getting Called-Out on Social Media case, what is the ethical problem in the case?

A) loyalty of co-worker versus trust of co-worker B) honesty of an individual versus freedom of speech C) honesty of the workplace versus the privacy of an individual D) privacy of an individual versus loyalty of co-worker

ESSAY. Write your answer in the space provided or on a separate sheet of paper.

81) Why do ethicists consider integrity to be the foundation of ethical behavior?

82) Moral philosophy deals with questions such as "How should I live my life?" and "What sort of person should I strive to be?" What are the basic tenets of moral philosophy? Answer with respect to the philosophies discussed in the chapter.

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83) Describe a situation you have encountered in your personal life where you did not follow the law because you judged another alternative to be more ethical. Don't use the example in the text of driving on a two-lane divided roadway. Why did you decide to do that act?

84) Evaluate Lance Armstrong's behavior toward doping during the Tour de France from the perspective of the "Six Pillars of Character." How might Armstrong have handled the matter better?

85) Why do you think potential employers of accounting graduates care about the ethical values of potential student hires?

86) Explain the steps that should be taken by an internal accountant/CMA when there is a difference of opinion with one's supervisor on an accounting or financial reporting manner.

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87) What is the role of a code of professional conduct and standards of ethical behavior for accountants and auditors?

88) Is it ethical for Jerry to keep his smart phone on during the work day if: (a) His daughter is sick and he needs to monitor messages from the baby sitter. (b) His ID has been stolen and he is waiting for the credit card company to inform him of the damages. (c) He likes to see what is posted about the company on social media so he can inform his bosses. (d) He feels as though all employees should have the leeway to be involved in social networking on the job within reasonable limits.

Discuss each of the above using ethical reasoning.

89) Are search results in Google, YouTube, Facebook, Twitter, and other social media sites fair game, specifically when an employer is looking to fire an employee?

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90) The school board has received a bomb threat claiming that a bomb would be detonated at noon on Monday at the high school. The threat was received by the school board at 8 pm on Sunday night. The school asked the bomb squad to investigate and they found no bomb. The next morning at 7 am, one hour before school was to start, another threat was received. There was no time to check for a bomb. What is the best action for the school to take from an ethical perspective? Explain. (a) Go ahead with school as planned since the last threat was not credible. (b) Delay the start of school until 10 am to give the bomb squad time to check and inform parents there is a water leak that needs to be fixed. (c) Call off school even though final exams were scheduled that day and explain all the steps taken to protect the safety of students.

Discuss which ethical theory supports each alternative. Which would you choose and why?

91) Susie, a newly graduated BBA in accounting, has started a new job with the state budgeting office. Susie has responsibility over expense reimbursements. The state has a travel policy stating that a state employee may be reimbursed up to $90 per night for a hotel room and up to $40 per day for meals, as long as the employee turns in food receipts. The first expense account Susie works on, the employee has a hotel receipt for $130 a night but no food expenses.

Susie processes the reimbursement for $90. The employee becomes irate as his reading of the travel policy is that he can be reimbursed for $130 a night for hotel and food with a receipt. The employee claims this has never been a problem in the past and has always been reimbursed $130 a night whether for hotel only or both hotel and food.

What should Susie do and why? Use ethical reasoning to support your answer.

92)

Why is it important to consider cultural variables in the workplace?

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Answer Key Test name: Chap 01_6e_ Mintz 1) B 2) A 3) B 4) B 5) D 6) A 7) C 8) A 9) D 10) C 11) B 12) D 13) A 14) D 15) D 16) D 17) A 18) C 19) A 20) B 21) C 22) A 23) C 24) B 25) A 26) B Version 1

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27) A 28) C 29) A 30) A 31) C 32) C 33) D 34) D 35) A 36) B 37) A 38) B 39) B 40) B 41) B 42) A 43) C 44) D 45) A 46) C 47) C 48) C 49) C 50) A 51) C 52) B 53) A 54) C 55) C 56) B Version 1

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57) C 58) C 59) B 60) C 61) C 62) D 63) A 64) D 65) C 66) D 67) B 68) D 69) A 70) D 71) D 72) C 73) B 74) D 75) A 76) A 77) D 78) A 79) C 80) B

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81)Integrity is an internal system of principles which guides our behavior. The rewards are intrinsic. Integrity is a choice rather than an obligation. Even though influenced by upbringing and exposure, integrity cannot be forced by outside sources. Integrity conveys a sense of wholeness and strength. When we are acting with integrity we do what is right—even when no one is watching.

People of integrity are guided by a set of core principles that empowers them to behave consistently to high standards. The core principles of integrity are virtues, such as: compassion, dependability, generosity, honesty, kindness, loyalty, maturity, objectivity, respect, trust, and wisdom. Virtues are the valuable personal and professional assets employees develop and bring to work each day. The sum of all virtues equals integrity.

There is a dynamic relationship between integrity and ethics, where each strengthens, or reinforces, the other. Personal integrity is the foundation for ethics—good business ethics encourages integrity. A person who has worked hard to develop a high standard of integrity will likely transfer these principles to their professional life. Possessing a high degree of integrity, a person's words and deeds will be in alignment with the ethical standards of the organization. The right thing to do is not always the easy thing.

It can be challenging for organizations to establish and then comply with their own ethical standards. Whether ethics are defined or not, employees at all levels experience pressures to act against ethical standards and counter to their own integrity. Some say one thing and then, in the heat of battle, do another. It takes awareness and courage to act in that moment; to hold out for a choice that is in alignment with the stated ethics of the organization and the integrity of those involved.

Integrity is what provides the inspiration to convert awareness into action. There is intrinsic satisfaction in accessing courage at times when Version 1

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our integrity is tested.

(Source: http://www.abundancecompany.com/ethics_integrity.htm).

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82)Moral philosophy is the area of philosophy concerned with theories of ethics, with how we ought to live our lives. Normative ethics is concerned with providing a moral framework that can be used in order to work out what kinds of action are good and bad, right and wrong.

Normative ethics is prescriptive—it establishes a set of ethical ideals one follows to lead "the good life." It is not descriptive; it doesn't describe how people actually do behave. There are three main traditions in normative ethics: virtue ethics, deontology, and consequentialism.

Four Sources of Ethical Standards The Utilitarian Approach Some ethicists emphasize that the ethical action is the one that provides the most good or does the least harm, or, to put it another way, produces the greatest balance of good over harm. The ethical corporate action, then, is the one that produces the greatest good and does the least harm for all who are affected-customers, employees, shareholders, the community, and the environment.

The Rights Approach Other philosophers and ethicists suggest that the ethical action is the one that best protects and respects the moral rights of those affected. This approach starts from the belief that humans have a dignity based on their human nature per se or on their ability to choose freely what they do with their lives. On the basis of such dignity, they have a right to be treated as ends and not merely as means to other ends. The list of moral rights includes the right to make one's own choices about what kind of life to lead. It is often said that rights imply duties-in particular, the duty to respect others' rights.

The Fairness or Justice Approach Aristotle and other Greek philosophers have contributed the idea that all equals should be treated equally. Today we use this idea to say that ethical actions treat all human beings equally—or if unequally, then Version 1

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fairly based on some standard that is defensible. We pay people more based on their harder work or the greater amount that they contribute to an organization, and say that is fair.

The Virtue Approach A very ancient approach to ethics is that ethical actions ought to be consistent with certain ideal virtues that provide for the full development of our humanity. These virtues are dispositions and habits that enable us to act according to the highest potential of our character and on behalf of values like truth and beauty. Honesty, courage, compassion, generosity, tolerance, love, fidelity, integrity, fairness, self-control, and prudence are all examples of virtues. Virtue ethics asks of any action, "What kind of person will I become if I do this?" or "Is this action consistent with my acting at my best?"

Putting the Approaches Together Each of the approaches helps us determine what standards of behavior can be considered ethical. There are still problems to be solved, however. The first problem is that we may not agree on the content of some of these specific approaches. We may not agree on what constitutes the common good. We may not even agree on what is a good and what is a harm.

The second problem is that the different approaches may not all answer the question "What is ethical?" in the same way. Nonetheless, each approach gives us important information with which to determine what is ethical in a particular circumstance. And much more often than not, the different approaches do lead to similar answers.

Making Decisions Making good ethical decisions requires a trained sensitivity to ethical issues and a practiced method for exploring the ethical aspects of a decision and weighing the considerations that should impact our choice of a course of action. Having a method for ethical decision making is Version 1

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absolutely essential. When practiced regularly, the method becomes so familiar that we work through it automatically without consulting the specific steps.

The more novel and difficult the ethical choice we face, the more we need to rely on discussion and dialogue with others about the dilemma.

Only by careful exploration of the problem, aided by the insights and different perspectives of others, can we make good ethical choices in such situations.

(Source: A Framework for Thinking Ethically, Markkula Center for Applied Ethics at Santa Clara University: http://www.scu.edu/ethics/practicing/decision/framework.html).

83)● Sometimes in natural disasters like a fire, flood, hurricane, a person might break in and enter a house to look for and rescue the occupants. ● Look for the reasoning behind a student's answer to evaluate the appropriateness of the action.

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84)Lance Armstrong's doping during the Tour de France shows loyalty only to himself. By doping, he showed a lack of trustworthiness, honesty, integrity, respect, and fairness to his competitors who played by the rules. He used and abused the system and duped the public into thinking he had honestly accomplished something he had cheated at for many years. His situation stands as an example of how quickly one's reputation for trust can be shattered.

An interesting article that explores how Armstrong's actions motivated others to act just as wrongly appears in a Harvard Business School posting at: http://hbswk.hbs.edu/item/lessons-from-the-lance-armstrongcheating-scandal.

When Armstrong chose to break the rules of professional cycling by taking illegal substances, he did more than put his own career in jeopardy—he betrayed millions of people who believed in him, and risked the reputations and careers of teammates in order to win personal glory.

"Once he decides to cheat, it is not just about him, he needs to create this whole infrastructure around him with this incredible organization to facilitate it," says Professor of Management Practice Clayton S. Rose, who sees in Armstrong's story an ideal vessel for teaching lessons about business ethics and leadership.

As much as Armstrong's story says about his own decision to betray his responsibilities, Rose sees more of a lesson in the decisions made by his followers—fellow riders, medical staff, and training staff—to go along with Armstrong's deceptions. "How do you start to go down that slippery slope?" Rose asks. "What can you do to stop yourself—and at what cost?"

Despite its emphasis on individual heroes, cycling is very much a team sport, one where the team supports the leader and works for his success.

Riders help shield their leader from other cyclists in tight packs, draft in Version 1

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front of him to reduce wind resistance during climbs, and chase down rivals who break from the group.

So when Armstrong decided to dope, he required other riders to dope as well to match his escalating performance level, and the rest of the support team to facilitate the doping and manage the cover-up to achieve victory.

85)Employers want trustworthy employees, which includes being honest, having integrity, being loyal and reliable. Employers want loyal employees who will respect the confidentiality of client information.

What makes a recent accounting graduate stand out to employers?

Possessing not only general accounting knowledge, but also nonaccounting skills. Whether it's written or oral communication skills, critical-thinking skills, problem-solving skills, or ethical-awareness skills, it's extremely important for accounting graduates to be wellrounded.

Critical-thinking, problem-solving, and ethical-awareness skills are important attributes to have when talking with a potential employer during an interview.

Employers want someone who can recognize a situation and understand what the ethical issues are, which paths to take, and know the difference between right and wrong, which is different from legal and illegal a lot of times. Something might be legal, but it may not necessarily be ethical.

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86)Since the conflict is with the supervisor, the accountant should clarify relevant ethical issues with an IMA Ethics Counselor or other impartial advisor to obtain a better understanding of possible courses of action.

The accountant should consult his own attorney as to legal obligations and rights concerning the ethical conflict. Issues arise with respect to confidentiality that must be fleshed out by discussions with one's attorney.

The example of Cynthia Cooper is a case in point how to handle such an ethical dilemma. Cooper first went to her superior, who really was on an equal footing within the organization—Scott Sullivan, the CFO. Sullivan insisted the accounting Cooper was challenging was acceptable. Cooper sensed the CEO—Bernie Ebbers—knew of the accounting but Sullivan was squarely in charge of these matters. Cooper then went to the chair of the audit committee who seemed relatively disinterested and not wanting to rock the boat. She persisted because of a good relationship with the chair. After striking out over a period of time, and discovering the scope of the fraud, Cooper approached the external auditors—KPMG at that time—and was successful in gaining their support on the accounting difference. Ultimately, Cooper and KPMG went to the board of directors and Sullivan was fired. Ebbers had already resigned.

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87)A code of conduct and standards of ethical behavior set the minimum behavior expected by the professional. Those regulations and standards exist to address the knowledge imbalance between the client and the provider of services, who has professional expertise. Clients trust their accountants and auditors in part because of the strict standards of ethical behavior in the profession.

Acting in the public interest involves having regard to the legitimate interests of clients, government, financial institutions, employers, employees, investors, the business and financial community, and others who rely upon the objectivity and integrity of the accounting profession to support the propriety and orderly functioning of commerce. This reliance imposes a public interest responsibility on the profession.

Auditors should take into consideration the public interest and reasonable and informed public perception in deciding whether to become involved in certain relationships with the client or client management that might impair objectivity and integrity by creating threats that cannot be mitigated by any safeguards developed by the client, the firm, or the regulators.

In acting in the public interest, a professional accountant shall observe and comply with provisions of a Code of Conduct such as that of the American Institute of CPAs and the Ethical Professional Standards of the IMA.

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88)(a) Is there another way for the babysitter or credit card company to contact Jerry besides the smart phone? Could Jerry receive personal calls on the company phone? Could he be reached via email?

Jerry is showing responsibility and caring for his family in being available when a child is sick. Others in the organization should be empathetic and realize the same thing might happen to them. They should ask under The Rights Theory: How would I want those in the organization to treat me if I felt compelled to have my smart phone on during the day to monitor my child's health? (b) In trying to be reached by the credit card company, can Jerry do these calls on his lunch hour or after work hours? Like with the babysitter, could Jerry receive personal call on the company phone or via email? In this case Jerry is crossing a fine line between the health and safety of oneself and family and a purely personal matter that could be handled at a later time. Even though others might say they would want to have access to their smart phones during work hours to resolve the credit card issue, it is not an emergency as the card is likely to be canceled by the company with Jerry's approval once a fraud report is issued. (c) and (d) can be supported using egoism. These situations show that Jerry is interested in his rights and being the first to tell his boss about postings on social media, possibly at the expense of his coworkers.

Students may try to use utilitarianism to support these positions.

However, Jerry should ask for permission from his employer to monitor social media sites during the work day. Maybe the employer is not interested in Jerry doing this or doesn't really concern itself with what others say about the employer on social media sites. The employer has a right to approve such use by Jerry and Jerry has an obligation to inform the employer of what he intends to do and why.

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For many companies, social media tools can provide new ways of connecting with potential and current customers, employees, suppliers, and other stakeholders. They offer companies the opportunity to speed up the pace of business, better establish the message that a company wants to convey, strengthen a company's relationships with customers and others, and further facilitate a continuous conversation about the business.

But social media when not well managed opens the door to numerous risks—breach of confidentiality, conflicts of interest, misuse of company resources, to name a few of the more obvious ones. A company without an initiative to effectively identify, assess, and manage its approach to social media and its various tools not only loses out on its many opportunities they offer but faces numerous risks to and improper business practices and activities that may damage the business. A program to harness these risks does not need to be onerous or intrusive, but it does need to be proportional to the company's exposure. Further, a company should expect the social media arena to continue to change both in technologies, their uses, business providers, and ways social media impacts the business landscape.

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89) The ethics involved in hiring are different than grounds for firing. In

regard to hiring, according to a Fall 2011 survey by Reppler, "more than 90% of recruiters and hiring managers have visited a potential candidate's profile on a social network as part of the screening process.

And a whopping 69% of recruiters have rejected a candidate based on content found on his or her social networking profiles—an almost equal proportion of recruiters (68%), though, have hired a candidate based on his or her presence on those networks." Whether they have stopped to ask if it is ethical or not, it seems employers are using the Internet to screen for potential employees.

While it is ethically questionable whether an employer should use social media in the hiring process, because of concerns such as antidiscrimination laws for hiring, the use of social media as one element of a process set in motion when considering firing an employee for cause makes more sense. An employer should be allowed to monitor open social media sites as grounds for firing an employee. According to a SpamTitan Technology survey, most employers agree with this position: "The results show that 87% of companies would consider firing an employee if they posted something confidential about the company on a social media site…"

With the rise in popularity of websites such as Facebook, Twitter, and LinkedIn, it is understandable that members of staff with Internet access are tempted to spend a little of their working day checking their accounts. For many employers the main issue is not the loss of productivity that occurs as a result of inappropriate social media use. It is the security threat that inappropriate social media use introduces.

But employers must tread lightly in this ethical area as well. The safest path is to create a social media policy for employees for how they represent the employer online. Policies range from a code of conduct to specific guidelines for every social media site available—protecting both Version 1

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the brand and name of the employer and spelling out fireable offenses for the employee. For the employer, protecting the name and brand can be equitable to profits and jobs that could be lost if an employee spreads damaging posts online. And social media policies only help the employee as well. It is true that employees have a right to express their frustration about their boss on Facebook, as long as they do not cross a predetermined line, a line that is very thin and ever—changing but one that should be drawn by each organization and made part of the culture.

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90) The question is designed to have no right answer but rather for the

student to display understanding of theories and critical thinking skills. (a) This may not require a theory. It is business as usual. Students may discuss the rights of students and parents for safety, and whether ethical blindness exists. It would seem an egoistic approach drives the inaction here. Students might discuss it in the context of Penn State and ignoring the child abuse in the interests of the reputation of the University. (b) This is considering protecting the public and students' interest but it is accomplished by telling a lie to achieve this end. Thus students should mention Kant on the duty to not tell a lie. Rights might also be mentioned as to whether the public, parents, and students have a right to know the truth. Act Utilitarianism, on the other hand, might be used to justify making up a story about a water leak—the least harm to the least many. (c) Final exams can always be re-scheduled. This is protecting the public and students' interest and is telling the truth. Thus students should mention Kant on the duty to not tell a lie and rights of the public, parents, and students to know the truth. Rule Utilitarianism can be used to emphasize the importance of never violating certain rules, which would include full disclosure to parents when their kids' health and safety are at stake.

Ask whether it might be best not to tell the public about the bomb threat because of the possibility of copycat incidents.

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91) This is written to have no right answer, but rather to have students

display their understanding of ethical theory and critical thinking skills.

The employee is using egoism to try to justify his position. Susie is using Kant to justify following the rules of the state. Some students may mention that using utilitarianism the state and employees will all be better off if the rule is $130 per night on travel, food, and entertainment.

What if cheaper hotels are available at the same quality? Should employees be expected to be selective in their choice of where to stay as they might be if it were a personal trip? Is there a difference between personal ethics and workplace ethics?

The employee claims the reimbursement at the higher level of $130 a night has never been a problem in the past whether for hotel only or both hotel and food. The first thing Susie should do is double check the company's policy on this matter. If the employee is correct, then the policy is routinely ignored perhaps in the interests of keeping employees happy. After all, it takes time to travel to a meeting; time that is not reimbursed. What's wrong with allowing an employee to be reimbursed at the higher level so long as all employees are treated the same?

On the other hand, policies should be followed as written even if there are negative consequences for an employee. The company can always change the policy to have it reflect the prevailing view about reimbursement. Of course such policies should be set by management, not the employees, although getting feedback from those employees who will be affected by the policy is a good management practice. It demonstrates diligence, empathy, and reasoned behavior, all virtues.

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92) Culture helps explain the priority of one's values. Working in a team

situation, members needs to understand the goals, which may include an agreed upon ranking of values. In Asian cultures, employees in a group may not feel obligated to inform outside the group if the rules are violated, whereas in a more Individualistic culture, an individual may feel a personal obligation to inform those who have a right to know. The implications for behavior in the workplace are significant depending on cultural dimensions.

As for Uncertainty Avoidance, in some cultures, the disclosure of information is quite guarded because of the fear that opening up about it creates uncertainty for the entity and may lead to negative consequences for all. In other cultures, uncertainty is expected and risk better managed.

Here is a review of Hofstede's work on cultural variables discussed in the chapter. Hofstede identified four cultural dimensions that can be used to describe general similarities and differences in cultures around the world: (1) individualism, (2) power distance, (3) uncertainty avoidance, and (4) masculinity. In 2001, a fifth dimension, long-term orientation—initially called Confucian dynamism—was identified.

Individualism (IDV) focuses on the degree that the society reinforces individual or collective achievement and interpersonal relationships. In individualist societies (high IDV), people are supposed to look after themselves and their direct family, while in collectivist societies (low IDV), people belong to "in-groups" that take care of them in exchange for loyalty. Imagine, for example, you are the manager of workers from different cultures and cheating/unethical behavior occurs in the workplace. A work group with collectivist values such as China and Japan (low IDV) might be more prone to covering up the behavior of one member of the group in order to "save face", whereas in the United Kingdom and United States (high IDV), there is a greater likelihood of Version 1

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an individual blowing the whistle.

Uncertainty Avoidance (UAI) is another cultural value that has important implications for workplace behavior, as it describes the tolerance for uncertainty and ambiguity within society. A high UAI ranking indicates that a country has a low tolerance of uncertainty and ambiguity. Such a society is likely to institute laws, rules, regulations, and controls to reduce the amount of uncertainty. A country such as Russia has a high UAI, while the United States and United Kingdom have lower scores (low UAI), indicating more tolerance for a variety of opinions. One implication is the difficulty of doing business in a country like Russia, which has strict rules and regulations about what can and cannot be done by multinational enterprises.

Other variables have important implications for workplace behavior as well, such as the Power Distance index (PDI), which focuses on the degree of equality between people in the country's society. A high PDI indicates inequalities of wealth and power have been allowed to grow within society, as has occurred in China and Russia as they develop economically. Long-term orientation (LTO) versus short-term orientation has been used to illustrate one of the differences between Asian cultures, such as China and Japan, and the United States and United Kingdom. In societies like China and Japan, high LTO scores reflect the values of long-term commitment and respect for tradition, as opposed to low-LTO countries, such as the United Kingdom and United States, where change can occur more rapidly. Time can often be a stumbling block for Western-cultured organizations entering the China market. The length of time it takes to get business deals done in China can be two or three times that in the West. One final point is to note that Brazil and India show less variability in their scores than other countries, perhaps reflecting fewer extremes in cultural dimensions.

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from different cultures might interact in the workplace. The key point is that cultural sensitivity is an essential ingredient in establishing workplace values and may affect ethical behavioral patterns.

Here are 7 key variables in cultural diversity in the workplace.

1.Communication - Many workplace cultural issues arise from differences in communication, such as direct versus indirect, content versus context. In direct cultures, people generally say what they mean, and content is king. In indirect cultures, such as Asia, Latin America, or the Middle East, people are likely to communicate indirectly, and you must be able to understand context to understand true meaning.

2. Values - One of the main differences in cultures is values. Some cultures might prize accomplishment, while others focus most on family or quality of life. Differences in values can be seen directly in the workplace. Cultures such as the United States favor competition and productivity, while others place greater value on harmony and cooperation.

3. Beliefs and Viewpoint - Another major variable in workplace cultural diversity is how people see the world, and how they interact with it. In the West, people believe they control events, and their destiny. But in most other cultures, people are fatalistic and often believe they have little control over events.

4. Social Structure - A couple of the big differences here are egalitarian or authoritarian societies and group or individual orientation. In the United States, for example, we tend to be very individualistic. But many Asian cultures, in contrast, are very group oriented and prefer to work in teams.

5. Time - Albert Einstein proved that time is relative, and this is certainly true across cultures. Americans tend to focus on short-term and believe deadlines are firm and fixed. In many other cultures, people think more long-term, and deadlines tend to be fluid.

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6. Etiquette - The main differentiator here is whether cultures are formal

or informal. In the United States, we tend to be very informal, as exemplified by the immediate use of first names. But in other cultures, people tend to be more formal, including the use of names proper greetings, etc.

7. Perceive the Individual - All this said, above all everyone must be seen as an individual. I recently hosted two visitors from Germany: one was an archetypal German, while the other might easily be mistaken as a California surfer. Cultures are only general guidelines.

Conclusion - We are all becoming world travelers in the workplace, fueled by immigration, outsourcing, and more. To be effective in a culturally diverse workplace, you need to know the rules and enjoy the challenge of cross-cultural interaction.

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Chapter 2: Cognitive Processes and Ethical Decision Making in Accounting MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

1) When Sally is asked why she should share her toys with her sister, she responds by saying "Because my mom says I have to and if I don't I'll go to time-out." In which stage of moral development is Sally?

A) conventional morality B) nonconventional morality C) postconventional morality D) preconventional morality

2) In reference to Rest's four-component Model of Morality, which component reflects an individual's willingness to place ethical values ahead of non-ethical values that relate to selfinterest?

A) moral character B) moral motivation C) moral sympathy D) moral judgment

3)

The cognitive development approach refers to A) the thought process followed in one's moral development.

B) the method of moral reasoning used in decision making.

C) the exercise of professional judgment in decision making.

D) the approach to giving voice to one's values.

4)

Kohlberg's model can best be described as

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A) the various phases in one's moral development and related levels of moral reasoning.

B) a model of ethical action that is based on the belief that one will not report incidents of wrongdoing if they believe others will report it.

C) a predictive tool to determine how a person will reason ethically based on one's views on diversity.

D) a model of age-specific levels of moral reasoning.

5) In the "Heinz and the Drug" case described in the chapter, if Heinz was reasoning at stage 5 he might decide to steal the drug based on which of the following reasonings?

A) Heinz should steal the medicine, because he will be much happier if he saves his wife, even if he will have to serve a prison sentence.

B) Heinz should steal the medicine, because his wife expects it.

C) Heinz should steal the medicine, because the law prohibits exceptions.

D) Heinz should steal the medicine, because everyone has a right to live, regardless of the law.

6) Which of the following might not describe Heinz's thought process in deciding whether to steal the drug if he were at stage 6?

A) Heinz should steal the medicine, because everyone has a right to live, regardless of the law.

B) Heinz should steal the medicine, because saving a human life is a more fundamental value than the property rights of another person.

C) Heinz should not steal the medicine, because that violates the golden rule of honesty and respect.

D) Heinz should not steal the medicine, because the scientist has a right to fair compensation.

7)

In stage 1 of Kohlberg's model, ethical reasoning is motivated by

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A) fear of punishment.

B) satisfaction of one's needs.

C) following the law.

D) acting based on universal ethical principles.

8)

In stage 3 of Kohlberg's model, ethical reasoning is motivated by A) satisfaction of one's needs.

B) acting in the best interests of others.

C) upholding the rights, values, and legal contracts of society.

D) acting based on universal principles.

9)

In stage 5 of Kohlberg's model, ethical reasoning is motivated by A) acting in the best interests of others.

B) following the law.

C) upholding the rights, values, and legal contracts of society.

D) acting based on universal principles.

10)

Individuals who reason at stage 6 incorporate ethical reasoning based on A) the morality of law and duty to the social order.

B) a rational calculation of benefits and harms to society.

C) universal ethical principles.

D) All of these choices are correct.

11) A client asks his accountant to ignore a mistake which overstated the accounts receivable account. The accountant decides that the accounts receivable account has to be corrected to state the correct amount based on the current accounting rules. Which stage of Kohlberg' Stages of Moral Development is the accounting reasoning?

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A) Stage 2 B) Stage 3 C) Stage 4 D) Stage 5

12) Which concept involves understanding each other and moving beyond simple tolerance to embracing and to celebrating the rich dimensions of individuality?

A) diversity B) equity C) inclusion D) sensitivity

13) Which concept is thought of in terms of equal opportunity that fits a person’s circumstances and abilities?

A) diversity B) inclusion C) equity D) sensitivity

14)

Rest's "Four Component Model of Morality" can best be described as

A) a model of moral development based on one's diversity perspective.

B) a model of the relationship between ethical action and one's level of moral development.

C) a model of moral judgment based on one's possession of certain virtues of behavior.

D) an approach to ethical decision making based on prescribed steps in making ethical decisions.

15) Assume you were assigned a term paper and decided to surf the web to identify a provider of papers for a fee. You chose what you thought was the best paper available. With respect to Rest's model of morality, it can be said that Version 1

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A) your actions lack moral sensitivity.

B) your actions are based on moral judgments.

C) you are making judgments based on expectations of your peer group.

D) you have made a decision based on the common good.

16) Yvonne is preparing a tax return for Jack. Jack wants to claim his nephew as a dependent even though he does not meet the criteria. Jack says if Yvonne does not list his nephew as a dependent, he will fire her and find a new tax accountant. Yvonne refuses because it is illegal to claim a dependent that does not meet the qualifications. Based on Yvonne's decision, she is likely reasoning at which stage of Kohlberg's moral development model?

A) Stage 2 B) Stage 3 C) Stage 4 D) Stage 5

17) James Rest's model of ethical action involves four components inherent to the ethical decision-making process. Which of the following relates to a person's moral judgment of what ought to be done?

A) interpreting a situation as a moral dilemma B) willingness to place ethical values ahead of non-ethical values C) intention to act ethically aligning to his values D) outcome of one's prescriptive reasoning

18)

Thorne's "Integrated Model of Ethical Decision Making" can best be described as

A) a depiction of a model of moral development.

B) a depiction of how the Principles in the AICPA Code of Professional Conduct influence decision making.

C) a model of the role of virtue in decision making.

D) a model of the role of moral development and virtue in decision making.

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19)

In Thorne's model of ethical decision making, the instrumental virtues relate to A) moral sensitivity.

B) ethical reasoning.

C) ethical motivation.

D) ethical character.

20)

A criticism of the Kohlberg model is that it A) suggests that people continue to change their decision priorities over time.

B) considers development of moral reasoning necessary to be a moral person.

C) makes deontological ethics superior to other ethical perspectives.

D) considers all complexities of decision making and behavior.

21) Using the conventional level of moral reasoning which is most likely the rationalization to Heinz's dilemma?

A) Saving a life is more important than keeping the law.

B) The needs of society are considered most.

C) The needs of the wife needing the drug are considered most.

D) The needs of the husband making the decision are considered most.

22) A(n) blank workforce is one where similarities and differences among employees in terms of different dimensions are molded together to produce the best outcome.

A) operational B) cognitive C) analogous D) diverse

23) Which describes unwelcome behavior that is severe, pervasive, or persistent enough to create a hostile or intimidating work environment?

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A) earnings management B) sexual harassment C) diversity, equity, and inclusion D) cognitive dissonance

24) The philosophical methods of moral reasoning suggest that once we have ascertained the facts, we should ask ourselves certain questions when trying to resolve a moral issue. Which of the following is not one of those questions?

A) Which course of action maximizes my net benefits?

B) Which course of action develops moral virtues?

C) Which course of action advances the common good?

D) What benefits and what harms will each course of action produce and which alternative will lead to the best overall consequences?

25) In organizations, a critical component of creating an ethical organization environment includes shared values, beliefs, goals, norms, and problem-solving mechanisms. These items can be described as A) conventional morality.

B) moral character.

C) diversity.

D) organizational culture.

26) In organizations, the ethical environment that is created in the workplace by the organization’s leadership is commonly called the A) tone at the top.

B) moral character.

C) diversity.

D) organizational culture.

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27) In organizations, the moral atmosphere of the work environment and the level of ethics practiced within a company is called the A) tone at the top.

B) moral character.

C) climate.

D) organizational culture.

28) Which of the following connect the integrated ethical decision-making process with Rest's framework?

A) identify the ethical and professional issues and ethical behavior B) identify and evaluate alternate courses of action and ethical sensitivity C) reflect on the moral intensity and virtues that enable action and ethical intent D) take action and ethical judgment

29) Wanda is faced with an ethical dilemma. She knows her supervisor, the CFO, wants to accelerate the recoding of revenue to an earlier period to "make the numbers," but Wanda is convinced this would violate GAAP. If Wanda reasons at stage 4 of Kohlberg's model, she is most likely to A) make a decision based on what is in her own best interests.

B) consider the interests of the stakeholders but decide based on what is in her best interests.

C) refuse to record the transaction as desired by the CFO. D) inform the board of directors of the difference of opinion with the CFO.

30) Keesha is the CEO of a publicly-owned company. She was informed by the CFO that the company's earnings were down 30 percent from the prior year due to the recession. The company's stock price has declined by 20 percent. The CFO comes up with a scheme to hide debt and inflate revenues by selling underperforming assets to a special purpose entity affiliated with the company. Keesha is concerned about possible effects on the creditors but ultimately she agrees to the accounting. Keesha is reasoning at

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A) Stage 1.

B) Stage 2.

C) Stage 3.

D) Stage 4.

31) Rosie is the external auditor of Texas Two Steps, a privately-owned dance company in Texas. Rosie believes the owner of the company is skimming cash off the top. She approaches the owner who explains that the money will be replaced in the following month after he refinances his house. Rosie accepts the owner's explanation but reclassifies the expenditure as a receivable of the company from the owner. Rosie's reasoning best reflects A) Stage 1.

B) Stage 2.

C) Stage 3.

D) Stage 4.

32) Steve is in charge of accounting for the purchase of equipment at Cal Works, Incorporated. The company has a policy that all expenditures greater than $1,000 (1% of total expenditures) have to be capitalized; less than $1,000 expensed. Steve is under pressure to report high earnings. He takes one $600 and $900 expenditure, adds them together, and records a capital expenditure for $1,500. Which of the following reasons and rationalizations might Steve use for his action A) one-time request.

B) standard Practice.

C) representational faithfulness.

D) materiality.

33)

Which bias involves a belief that the world is more predictable than it actually is?

A) deterministic bias B) hindsight bias C) framing bias D) attribution bias

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34) Which bias involves a tendency to believe past outcomes were expected or known before they occurred?

A) authoritative bias B) framing bias C) hindsight bias D) oversimplification bias

35) Which bias involves a belief that theories about the world also suggest that we tend to blame individuals for events, rather than their work environment, policies and procedures, or incentive programs?

A) attribution bias B) hindsight bias C) framing bias D) financial bias

36)

Daniel Kahneman's System 1 thinking is described by all of the following except for A) automatic.

B) emotional.

C) intuitive.

D) reflective.

37)

Which of the following statements best describes System 2 thinking?

A) System 2 operates automatically and quickly, with little or no effort and no sense of voluntary control.

B) System 2 allocates attention to the effortful mental activities that demand it, including complex computations.

C) An example of System 2 thinking is detecting that one object is more distant than another.

D) An example of System 2 thinking is effortlessly originating impressions and feelings about an event.

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38)

Cognitive dissonance creates a problem that can be described as A) inconsistency between thoughts and beliefs and our intended actions.

B) consistency between thoughts and beliefs and our intended actions.

C) reducing the importance of the beliefs and attitudes on our actions.

D) acquiring new information that outweighs the dissonant beliefs.

39) is

An example from the book of someone who may have experienced cognitive dissonance

A) Joe Paterno.

B) Cynthia Cooper.

C) Betty Vinson.

D) Richard Scrushy.

40) Which of the following characteristics is not part of the behavioral approach, Giving Voice to Values?

A) Uses post-decision-making B) Capacity to express one's values C) Employs traditional philosophical reasoning D) Counteracts reasons and rationalizations

41) In using the GVV framework, which of the follwing is not a question to pose for dealing with the opposing points of view?

A) What is the way to appeal all parties?

B) What is at stake for the key parties?

C) What is your most powerful and persuasive response you need to address?

D) What levers can you use to influence others?

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42) In the A Team Player case discussed in the chapter, which is the primary reason and rationalization that Barbara may need to counter for not informing Jessica of the inventory deficiency?

A) The inventory deficiency is immaterial.

B) Not accounting for the inventory deficiency is standard practice.

C) The inventory deficiency is not the team’s responsibility.

D) The inventory deficiency is a one-time occurrence and will not happen again.

43) Which of the following is not one of the levers Larry Davis might use to convince Paul Jones about the rightness of his point of view in the Ace Manufacturing case discussed in the chapter?

A) Davis can ask Paul Jones for supporting documentation to back up the coding of expenses to different accounts.

B) Davis can try to convince Paul that his actions are harmful to the company and potentially very embarrassing for his dad.

C) Davis can threaten to go to all the owners if Paul doesn't admit the mistake and take corrective action.

D) Davis can threaten to go to the SEC to protect shareholder interests if Paul agrees to pay back the amounts taken out of the company and correct the accounting.

44) Assume your values conflict with what you are being asked to do. Under the Giving Voice to Values methodology, which of the following statements reflects the thought process you might have in developing a game plan to voice your values?

A) Use philosophical ethical theories to reason through alternative courses of action.

B) Use the ethical decision-making model to evaluate the ethics of the situation.

C) Reflect on the objections that might be raised to your intended expressed views.

D) Use Systems 2 thinking to decide on a course of action.

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45) Gabby has just left a meeting with the partner in charge of an audit engagement and was told to ignore the typical year-end accrual entries because earnings are below financial analysts' earnings expectations. Gabby knows this is wrong and wants to act on her values but she does not want to lose her job. What is the best thing for Gabby to do in this situation if she chooses to voice her values?

A) quit the firm B) speak with the managing partner of the firm C) inform the SEC of the difference D) All of these choices are correct.

46)

Which of the following describes the ethical conflict in A Team Player?

A) There is no conflict; Barbara and Diane both identify the deficiency.

B) The conflict is between Diane and the rest of the audit team on whether there is a deficiency.

C) The conflict is between Barbara and Haley, and the rest of the team as to whether or not to take the deficiency to Jessica, the audit senior.

D) The conflict is between Barbara and the rest of the team as to whether or not to take the deficiency to Jessica, the audit senior.

47) Which of the following best characterizes the ethical conflict Alex is facing in the FDA Liability Concerns?

A) Alex and Michael can't convince Gregory of the extent of the problem caused by the listeria identified by the FDA. B) Alex wants to do the right thing by consumers of his salad oil products but Michael objects based on his cost-benefit analysis.

C) Alex and Michael want to make the plant seem as profitable as possible so the firm can do an IPO and cash out their shares but Gregory wants to inform the FDA of the extent of the listeria problem.

D) Gregory and Michael are using cost-benefit analysis to pay fines and do the minimum for the FDA while Alex wants to comply fully.

48) The ethical dilemma for Hailey in "Taxes and the Cannabis Business" case can best be described as a Version 1

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A) conflict between reporting cash sales and ignoring them.

B) conflict between reporting expenses and ignoring them.

C) lack of independence due to ties to the client entity.

D) lack of due care in not spotting improper tax accounting.

49)

What ethical action should Daniel take in A Faulty Budget?

A) Work with Pete to correct the budget so JB, Pete's boss, does not find out.

B) Work with Pete to keep quiet about the mistake in the budget so the new hires will not be laid off.

C) Tell JB about the mistake in the budget but only half of the actual mistake so that employees will not be laid off.

D) Tell JB about the mistake in the budget so the company can make corrections as soon as possible.

50) In the “Faulty Budget” case, Jackson Daniels could use all the following levers to counter the reasons and rationalizations Jimmy (Pete) Beam might give for requesting that Jackson conceal his error except A) stressing his ethical obligation is ensuring that employees are not laid off.

B) seeking advice from friends and family.

C) identifying individuals who can provide support.

D) providing a resolution to the problem rather than complaining about it.

51) Which of the following was not one of the recommendations that Uber implemented after charges of sexual harassment were made?

A) training key personnel B) providing an effective complaint process C) encouragingquid pro quo D) creating a board oversight committee

52)

The "Milton Manufacturing" case illustrates

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A) what can go wrong when a company sets a policy that potentially harms one area of its operations.

B) how the failure to exercise professional skepticism can cloud objective judgment.

C) the pressure that can be placed on accountants by top management.

D) what can go wrong when fraudulent accounting is dictated by top management.

53) The ethical dilemma in the “Not so Diverse, Equitable or Inclusive” case can best be described as A) how the failure to exercise professional skepticism can cloud objective judgment.

B) disproportionately high turnover for persons of color and women.

C) improper training and supervision of new employees.

D) sexual harassment of young female employees.

54) In the Racially Charged Language case, which of the following is not one of the EDI initiatives discussed in the case A) create an inclusive community where all students thrive.

B) establish goals to retain underrepresented groups.

C) allow flyers using racial slurs.

D) implement a 12-week training program.

55) Cynthia Cooper's actions in the WorldCom case can be best characterized as demonstrating A) courage and expediency.

B) persistence and courage.

C) courage and loyalty.

D) persistence and loyalty.

56)

The ethical dilemma in the Chefs Delight case can best be described as

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A) reclassification of marketable securities to increase reported income.

B) disproportionately high turnover for persons of color and women.

C) improper training and supervision of new employees.

D) sexual harassment of young female employees.

57) The ethical dissonance model looks at the ethical fit of the organizational and individual values. The optimal fit for an individual with high individual ethics would be A) High-High.

B) High-Low. C) Low-High.

D) Low-Low.

58)

The Ethical Dissonance Model helps to evaluate A) whether the organization sets an ethical tone at the top.

B) whether the organization has ethical leadership.

C) whether the organization has a whistle-blowing process.

D) whether the organization's ethics aligns with individual ethics.

59)

The role of a leader in an organization is to A) establish principles and standards of behavior that guide business decisions.

B) enforce violations of code rules of conduct.

C) determine organizational climate and define norms.

D) develop the principles and strategic initiatives to guide ethical action.

60)

An ethical climate is enhanced by all of the following except

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A) a values-driven organization.

B) openness and transparency.

C) fear of retaliation.

D) supportive environment.

61)

An ethical corporate culture includes A) zero tolerance for individual and collective mistakes.

B) an explicit statement of values.

C) a focus on results over process.

D) a culture of do what I say, not what I do.

62)

The best way to characterize the role of Sherron Watkins in the downfall of Enron is

A) she directed the internal auditors to examine numerous transactions that led to the discovery of the fraud.

B) she gave in to the pressure of Andy Fastow to go along with materially misstated financial statements.

C) she was sent to jail even though she cooperated with the government in its case against Enron.

D) she tried to alert Ken Lay about the accounting scandal at Enron.

ESSAY. Write your answer in the space provided or on a separate sheet of paper.

63) At which stage of moral development are most accountants and auditors with respect to their decision making? What factors are responsible for their being at that stage? Given the stage of moral development you think you are at, how does this relate to the stage of moral reasoning of most accountants and auditors? What conflicts might exist for you in the workplace?

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64) Explain how virtue interacts with moral development in Thorne's Integrated Model of Ethical Decision-making.

65) Assume your supervisor has reduced the number of hours you charged to the client because it was over budget. You will not be paid for those hours. What would you do and why?

Use ethical reasoning.

66) Describe the Giving Voice to Values framework. What are the reasons and rationalizations frequently given in financial statement fraud situations?

67) As an executive in a mid-sized manufacturing firm, Cal finds himself thrown together with Harry, who works for a division of the firm that Cal supervises. He and Harry are in the same community; their children are in the same schools; they often show up at the same social functions; and they play golf together fairly frequently.

One day, to Cal's deep dismay, he hears that Harry has been implicated in some financial irregularities at work. The issues while serious leave some room for doubt. There is reason to think Harry got ensnared by regulations, though he may have afterward tried to cover up that entanglement by being less than forthright. Yet after what Cal observes to be a careful audit and investigation, Harry is let go from his job.

Harry comes to Cal and asks for a letter of recommendation.

What should Cal do? What are the consequences of the options?

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68) As a professional working for a large electronics firm, Stan found himself riding a roller coaster of concern about lay-offs. Every few years, top management slashed jobs as work slacked off - only to hire again when things were looking up. So when Stan and his team members noticed that the executives were again meeting behind closed doors, they suspected the worst.

Stan's boss revealed to Stan that Stan's team member Jim was slated to lose his job. However, it was made plain that Stan was to keep that information confidential.

Not long after that conversation, Jim approached Stan and asked whether he could confirm the rumor that he would be laid off.

Stan has decided to tell Jim but first wants to convince management of the rightness of his action. What might he say to who and why? What are the reasons and rationalizations he may have to counter in making his argument?

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69) Taken from Case 1-2 Giles and Regas.

Ed Giles and Susan Regas have never been happier than during the past four months since they have been seeing each other. Giles is a 35-year-old CPA and a partner in the medium-sized accounting firm of Saduga & Mihca. Regas is a 25-year-old senior accountant in the same firm.

Although it is acceptable for peers to date, the firm does not permit two members of different ranks within the firm to do so. A partner should not date a senior in the firm any more than a senior should date a junior staff accountant. If such dating eventually leads to marriage, then one of the two must resign because of the conflicts of interest. Both Giles and Regas know the firm's policy on dating, and they have tried to be discreet about their relationship because they don't want to raise any suspicions.

While most of the staff seem to know about Giles and Regas, it is not common knowledge among the partners that the two of them are dating. Perhaps that is why Regas was assigned to work on the audit of CAA Industries for a second year, even though Giles is the supervising partner on the engagement.

As the audit progresses, it becomes clear to the junior staff members that Giles and Regas are spending personal time together during the workday. On one occasion, they were observed leaving for lunch together. Regas did not return to the client's office until three hours later. On another occasion, Regas seemed distracted from her work, and later that day, she received a dozen roses from Giles. A friend of Regas's who knew about the relationship, Ruth Revilo, became concerned when she happened to see the flowers and a card that accompanied them. The card was signed, "Love, Poochie." Regas had once told Revilo that it was the nickname that Regas gave to Giles.

Revilo pulls Regas aside at the end of the day and says, "We have to talk."

"What is it?" Regas asks.

"I know the flowers are from Giles," Revilo says. "Are you crazy?"

"It's none of your business," Regas responds.

Revilo goes on to explain that others on the audit engagement team are aware of the relationship between the two. Revilo cautions Regas about jeopardizing her future with the firm by getting involved in a serious dating relationship with someone of a higher rank. Regas does not respond to this comment.

Regas promises to talk to Giles and thanks Revilo for her concern. That same day, Regas telephones Giles and tells him she wants to put aside her personal relationship with him until the CAA audit is complete in two weeks. She suggests that, at the end of the two-week period, they get together and thoroughly examine the possible implications of their continued relationship.

Giles reluctantly agrees.

However, Giles appears at the CAA audit a few days later. He pulls Regas aside and states, "I do want to put our relationship on hold until after this audit."

"We cannot be talking about this now! The audit team or the client could hear."

"Then let's have dinner tonight to discuss it. I won't leave until you say yes."

"Okay."

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As Regas is returning to the audit room, Revilo says, "The team is uncomfortable with you and Giles having personal conversations in front of them. You promised this would stop."

"I appreciate your concerns again. I am working on it! Please give me some time and space."

"You don't have much time. Some of the teams are talking of going to HR or the managing partner about the situation."

Required: Analyze the case using GVV. ● What are the main arguments Revilo (and the audit team) are trying to counter? What the reasons and rationalizations Revilo needs to address? ● What is at stake for the key parties? ● What levers can Revilo use to influence Regas and Giles? ● What is the most powerful and persuasive response to the reasons and rationalizations Revilo needs to address? To whom and when?

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70) Taken from Case 1-7 Eating Time.

Kevin Lowe is depressed. He has been with the CPA firm Stooges LLP for only three months.

Yet the partners in charge of the firm—Bo Chambers and his brother, Moe—have asked for a "sit-down." Here's how it goes: "Kevin, we asked to see you because your time reports indicate that it takes you 50 percent longer to complete audit work than your predecessor," Moe said.

"Well, I am new and still learning on the job," replied Lowe.

"That's true," Bo responded, "but you have to appreciate that we have fixed budgets for these audits. Every hour over the budgeted time costs us money. While we can handle it in the short run, we will have to bill the clients whose audit you work on a larger fee in the future. We don't want to lose clients as a result."

"Are you asking me to cut down on the work I do?" Lowe asked.

"We would never compromise the quality of our audit work," Moe said. "We're trying to figure out why it takes you so much longer than other staff members."

At this point, Lowe started to perspire. He wiped his forehead, took a glass of water, and asked, "Would it be better if I took some of the work home at night and on weekends, completed it, but didn't charge the firm or the client for my time?"

Bo and Moe were surprised by Kevin's openness. On one hand, they valued that trait in their employees. On the other hand, they couldn't answer with a yes. Moe looked at Bo, and then turned to Kevin and said, "It's up to you to decide how to increase your productivity on audits.

As you know, this is an important element of performance evaluation."

Kevin cringed. Was the handwriting on the wall in terms of his future with the firm?

"I understand what you're saying," Kevin said. "I will do better in the future—I promise."

"Good," responded Bo and Moe. "Let's meet 30 days from now and we'll discuss your progress on the matters we've discussed today and your future with the firm."

In an effort to deal with the problem, Kevin contacts Joyce, a friend and fellow employee, and asks if she has faced similar problems. Joyce answers "yes" and goes on to explain she handles it by "ghost-ticking." Kevin asks her to explain.

"Ghost-ticking is when we document audit procedures that have not been completed." Kevin, dumbfounded, wonders, what kind of a firm am I working for?

After much consideration Kevin asks for a meeting with Bo and Moe within week. Kevin does not want to take work home and off the clock. He wants the meeting to convince Bo and Moe that having auditors work off the clock and at home is not in the best interest of the firm and its mission to do independent audits with integrity, objectivity, and due professional care.

Required: Analyze the case using GVV. ● What are the main arguments Kevin is trying to counter? What are the reasons and rationalizations Kevin needs to address? ● What is at stake for the key parties? ● What levers can Kevin use to influence Bo and Moe?

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● What is the most powerful and persuasive response to the reasons and rationalizations Kevin needs to address? To whom and when?

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71) Taken from Case 1-9 Cleveland Custom Cabinets.

Cleveland Custom Cabinets is a specialty cabinet manufacturer for high-end homes in the Cleveland Heights and Shaker Heights areas. The company manufactures cabinets built to the specifications of homeowners and employs 125 custom cabinetmakers and installers. There are 30 administrative and sales staff members working for the company.

James Leroy owns Cleveland Custom Cabinets. His accounting manager is Marcus Sims, who reports to the director of finance, Alison Mayhew. Sims manages 15 accountants. The staff is responsible for keeping track of manufacturing costs by job and preparing internal and external financial reports. The internal reports are used by management for decision making. The external reports are used to support bank loan applications.

On April 10, 2016, Leroy came into Sims's office to pick up the quarterly report. He looked at it aghast. Leroy had planned to take the statements to the bank the next day and meet with the vice president to discuss a $1 million working capital loan. He knew the bank would be reluctant to grant the loan based on a net income of $90,000 on revenue of $6,400,000. Without the money, Cleveland could have problems financing everyday operations.

Leroy called Mayhew to come to Sims's office. Leroy then asked for an explanation of how net income could have gone from 14.2 percent of sales for the year ended December 31, 2015, to 1.4 percent for March 31, 2016. Sims pointed out that the estimated overhead cost had doubled for 2016 compared to the actual cost for 2015. He explained to Leroy that rent had doubled and the cost of utilities skyrocketed. In addition, the custom-making machinery was wearing out more rapidly, so the company's repair and maintenance costs also doubled from 2015.

Leroy wouldn't accept Sims's explanation. Instead, he told Sims that the quarterly income had to be at least the same percentage of sales as at December 31, 2015. Mayhew agreed with Leroy and said there had to be a mistake and it would be corrected. Sims looked confused and reminded Leroy and Mayhew that the external auditors would wrap up their audit on April 30. Leroy told Sims not to worry about the auditors. He would take care of them. Furthermore, "as the sole owner of the company, there is no reason not to 'tweak' the numbers on a one-time basis. I own the board of directors, so no worries there." He went on to say, "Do it this one time and I won't ask you to do it again." He then reminded Sims of his obligation to remain loyal to the company and its interests. Sims started to soften and asked Leroy just how he expected the tweaking to happen. Leroy flinched, held up his hands, and said, "I'll leave the creative accounting to you and Mayhew."

Required: Analyze the case using GVV. ● What are the main arguments Sims is trying to counter? What are the reasons and rationalizations Sims needs to address? ● What is at stake for the key parties? ● What levers can Sims can use to influence Leroy and Mayhew? ● What is the most powerful and persuasive response to the reasons and rationalizations Sims needs to address? To whom and when?

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72) Explain what is meant by the ethical-person organization exchange and ethical dissonance including its implications for workplace ethics.

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Answer Key Test name: Chap 02_6e_ Mintz 1) D 2) B 3) A 4) A 5) D 6) D 7) A 8) B 9) C 10) C 11) C 12) A 13) C 14) B 15) A 16) C 17) D 18) D 19) D 20) C 21) C 22) D 23) B 24) A 25) D 26) A Version 1

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27) C 28) C 29) C 30) C 31) D 32) D 33) A 34) C 35) A 36) D 37) B 38) A 39) C 40) C 41) A 42) A 43) D 44) C 45) B 46) C 47) B 48) A 49) D 50) A 51) C 52) A 53) B 54) C 55) B 56) B Version 1

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57) A 58) D 59) C 60) C 61) B 62) D 63)Kohlberg's theory of ethical development provides a framework that can be used to consider the effects of conflict areas on ethical reasoning in accounting. For example, if an individual accountant is influenced by the firm's desire to "make the client happy," then the result may be reasoning at Stage 3. The results of published studies during the 1990s by accounting researchers indicate that CPAs reason primarily at Stages 3 and 4. One possible implication of these results is that a larger percentage of CPAs may be overly influenced by their relationship with peers, superiors, and clients (Stage 3) or by rules (Stage 4). A CPA who is unable to apply the technical accounting standards and rules of conduct critically when these requirements are unclear is likely to be influenced by others in the decision-making process. If an auditor reasons at the post conventional level, then that person may refuse to give in to the pressure applied by the supervisor to overlook the client's failure to follow GAAP. Students should pick a stage and give examples of why they are at that stage and try to link it to being an accounting professional.

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64)One question that arises from Rest's model is how to align ethical behavior with ethical intent. The answer is through the exercise of virtue, according to a study conducted by Libby and Thorne.

Professional judgment requires not only technical competence, but also depends on auditors' ethics and virtues. The authors concluded from their study that virtue plays an integral role in both the intention to exercise professional judgment and the exercise of professional judgment, and the necessity of possessing both intellectual and instrumental virtues for auditors.

Thorne develops a model of individuals' ethical decision-making processes that integrates Rest's components with the basic tenets of virtue ethics theory. Her model relies on virtue-based characteristics, which tend to increase the decision maker's propensity to exercise sound ethical judgment. Thorne believes that virtue theory is similar to the approach advocated by the cognitive-developmental perspective in three ways. First, both perspectives suggest that ethical action is the result of a rational decision-making process. Second, both perspectives are concerned with an individual's ethical decision-making process. Third, both perspectives acknowledge the critical role of cognition in individuals' ethical decision making.

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65)The supervisor changing your time after you worked it is a form of stealing. This question requires students to explore the pressure to cheat or lie. This is good way to discuss the slippery slope of ethical situations.

It also deals with how the culture of a firm (i.e., eat time) should affect one's actions when trying to act ethically.

Ethical Issues Rights Perspective: Working without being paid is setting one up for burn-out, if not a health safety threat. Employees have the right to receive a competitive wage. One should consider the short- and long-run consequences. In the short run, one does not hurt anyone but himself and his family if he doubles up on work and sacrifices family responsibilities. In the long run, the client gets a cheaper audit and a worse audit as one will start cutting corners since one might not be paid after the fact. Going along with the supervisor starts one lying and the slippery slope of being secretive, deceitful, and telling more lies.

Six Pillars values include trustworthiness, responsibility, fairness, caring, and citizenship.

Students should acknowledge their responsibilities not only to themselves but other staff who might get caught up in similar sacrifices.

This matter needs to be brought up at the highest levels of the organization. It is dishonest, uncaring, and may establish a culture of deceit. Maybe the time budgets are too tight to support a lower bid for audit services. Does the company do this with other clients? On other audits? Am I setting myself up to fail…eventually?

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66)"Giving Voice to Values (GVV)" is a behavioral ethics approach that shifts the focus away from traditional philosophical reasoning to an emphasis on developing the capacity to effectively express one's values in a way that positively influences others by finding the levers to effectively voice and enact one's values. The methodology asks the protagonist to think about the arguments others might make that create barriers to expressing one's values in the workplace and how best to counteract these "reasons and rationalizations." GVV is used postdecision-making, that is, you have already decided what to do. It can be used to ward off the necessity for whistle-blowing if by voicing values others can be convinced about the wrongness of their intended behavior/decisions.

GVV provides a framework to deal with the opposing points of view based on the following series of questions. ● What are the main arguments you are trying to counter? That is, what are the reasons and rationalizations you need to address? ● What is at stake for the key parties, including those who disagree with you? ● What levers can you use to influence those who disagree with you? ● What is your most powerful and persuasive response to the reasons and rationalizations you need to address? To whom should the argument be made? When and in what context?

The most frequent categories of argument or rationalization that we face when we speak out against unethical practice. Some of the most common arguments include: ● Expected or Standard Practice: "Everyone does this, so it's really standard practice. It's even expected." ● Materiality: "The impact of this action is not material. It doesn't really hurt anyone." ● Locus of Responsibility: "This is not my responsibility; I'm just Version 1

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following orders here." ● Locus of Loyalty: "I know this isn't quite fair to the customer but I don't want to hurt my reports/team/boss/company." ● Isolated Incident: "This is a one-time request; you won't be asked to do it again."

A good example in accounting is the WorldCom fraud. Betty Vinson was convinced it was a one-time request. She felt the need to be loyal and a team player. She believed Scott Sullivan knew what was the correct accounting because of his higher position, and rationalized she did not develop the questionable accounting. She was just following orders.

On the other hand, Cynthia Cooper was the hero in the WorldCom fraud ordering her internal audit staff to do an exhaustive investigation into the recording of "prepaid capacity" costs, which were payments for telecommunications access on other providers' networks that should have been expensed as incurred each year but, instead, were capitalized to show a higher level of earnings. Cooper knew it was her responsibility as the vice president of internal audit to make sure the improper accounting was corrected. She knew it was material in amount and wasn't (or shouldn't have been) standard practice. She did not fall for the "locus of loyalty" argument of Scott Sullivan, the CFO.

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67)Cal is facing a dilemma of being loyal to Harry or being forthright and honest about the situation. From a deontology approach, Cal must be truthful in any letter. From Act Utilitarianism, the "best" end result may be to help Harry find another job and disguise the truth. Rule Utilitarianism would hold that it is not right to lie, as would Rights Theory. The universal perspective asks Cal to consider how he would feel if another employer wrote a dishonest letter to Cal and he hired Harry as a result. From a virtue approach, Cal will need to put himself in the position of the new employer hiring Harry and what he would want to know about Harry. All of these could be related to Kohlberg's stages of moral development also.

The consequence of these options is that Harry could obtain a job based upon Cal's recommendation. If Harry again is again found implicated in financial irregularities and if the new job found out that Cal knew, Cal's reputation will be harmed. This is a situation where empathy helps in that Cal should put himself in the position of a prospective employer of Harry. Still, it is oftentimes difficult to say something negative about an associate or friend. Some in Cal's position might inform a prospective employer that Harry was let go because of differences and leave it at that. It is kind of a half-truth that sometimes dictates the action out of loyalty to another or stage 3 reasoning rather than to view one's responsibilities to society (another firm), which requires stage 4 thinking or above.

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68)Stan should approach Stan's boss and explain that Jim has directly asked him if he will be laid off. Jim and other coworkers have noticed the many closed-door meetings and fear that another round of lay-offs is coming. Stan should explain how Jim and coworkers would appreciate honesty and transparency in knowing about the lay-offs. The affected workers could start looking for another job. Stan needs to be empathetic to Jim's position and the concerns of other workers who have a right to know if their jobs are in jeopardy. Jim and the other workers trust Stan as the team leader to look out for their best interests in return for loyalty to the team and diligent work.

Stan's boss is likely to use the reasons and rationalizations of "this is standard practice;" and "this is not my responsibility; I'm just following orders." Stan should try reasoning that his boss would want to know if he himself were being laid off. This would follow the Golden Rule, deontology, enlightened egoism, and virtues. Stan should ask his boss about who has the responsibility in making the layoff decisions; he would like to talk to that person.

If Stan acts in these ways, he will gain the trust of other employees and even management who, in the long run, may see Stan's loyalty as a plus for the firm.

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69)Giles, a partner, and Regas, a senior, are working on the CAA audit and dating for the last four months in spite of the firm's policy that a relationship between two members of different ranks within the firm is not permitted. The audit team realizes that Regas and Giles are dating and are uncomfortable with the situation. Revilo lets Regas know that the team knows about the relationship, but Regas promises that she will take care of it and is not open to further discussion.

After the latest witnessing of Regas and Giles at the audit, Revilo and the team need to have a discussion with Regas or Giles. At present, the team is more comfortable approaching Regas since she is their senior.

The team needs to express their discomfort about Giles and Regas dating while working on the CAA audit. Revilo or another brave team member should tell Regas how knowing about the relationship makes them complicit in having to keep a secret since the firm bans relations between employees at different ranks. They can explain that some of the discomfort is the fear of how their evaluations and jobs could be affected by the relationship.

Regas may explain that although the firm has a policy of no dating between ranks, many do so (standard practice rationalization). She could state that she has to work with Giles out of loyalty to wind the relationship down until after the audit (locus of loyalty). She might also state that the relationship was not intentional and just happened (form of an isolated incident). She might also state that the relationship is special because she loves Giles and he loves her.

Regas and Giles have their jobs, evaluations, and future raises at stake.

Their reputations for integrity and professionalism are also at stake. The team has a tense working condition with Regas and Giles dating. The team members are fearful of what will happen if they keep quiet, or if they speak up about the relationship. The accounting firm has its reputation at stake to provide an audit with integrity and due Version 1

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professional care. The client and the public have an independent audit at stake. That is, if the client or the public finds out about the relationship of Giles and Regas it could taint whether the audit was independent, done with integrity and due professional care.

Revilo and the team should use the lever of Regas should not jeopardize her reputation as a CPA by breaking the policy as it calls into question whether Regas and Giles are breaking other rules and policies. Have they been cutting corners in performing the audit because their attention has been diverted by the dating relationship? Other levers might be that the team might go to HR, or maybe one of the mentors assigned to the team members. The team members might explain that Regas seems to be acting out of self-interest or egoism. They should encourage Regas to act out of virtues, deontology, and utilitarianism and CPA principles of integrity and due professional care.

Revilo and the team should confront Regas at the end of the work day to express their concerns on Regas's relationship with Giles. It is possible that the students will consider the threat to go to HR as the most powerful and persuasive argument. The team or Revilo could approach HR and simply state they are concerned that Regas' attention has been diverted and they hope she is all right.

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70)Kevin is trying to counter the arguments that staff working hours without charging the client or being paid for the time worked is good for the accounting firm, the client, and the staff. From a rights perspective, working a regular overtime without being paid or an overnighter is setting one up for burn-out, if not a health safety threat. Employees have the right to receive a competitive wage. There are short- and long-run consequences of having staff work overtime without being paid. In the short run, Kevin does not hurt anyone but himself and his family if he doubles up on work and sacrifices family responsibilities. In the long run, the client gets a cheaper audit and a worse audit if Kevin starts cutting corners; the partners get higher profit than if the staff was paid for actual hours worked. The long-term effect to Kevin is that he learns secrecy, deceit, and lies. The Six Pillars of Character includes the values of trustworthiness, responsibility, fairness, caring, and citizenship.

Bo and Moe will likely use the reasons and rationalizations of having staff work without being paid for overtime as the expected or standard practice in public accounting. It could be explained as an isolated incident by rationalizing that it is a one-time request for the current engagement only or, that it is not that much time being "eaten" (materiality) and only would occur during busy season (isolated incident). The locus of loyalty reason to service the client within budget might be given. The firm expects loyalty from their workers and to act in the best interests of the firm and its clients.

The key parties have much at stake. Bo and Moe and the firm have their reputations for high-quality audits performed with due professional care.

Kevin has his job and reputation as a team player at stake. The other staff members of the firm have the potential of being paid for overtime instead of being pressured to work overtime without being paid. The clients have the potential of higher cost audits in the future to pay all of the staff's hours worked, but should be assured that the audits will be Version 1

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performed with due diligence and professionalism. The accounting profession and public have the reputation of quality audits in the free market system at stake.

Kevin should use the principles of the accounting profession — independence, integrity, objectivity, and due professional care — as levers to influence Bo and Moe. He should also use the ethical reasoning of virtues, deontology, rule utilitarianism, enlightened egoism to support his view. He should emphatically state the risk for the firm's and individual CPAs' reputation if corners are cut due to working overtime.

Cut corners can lead to audit failures, if materials errors and frauds are not discovered in the audit.

The most powerful and persuasive argument could be that Bo and Moe are wrong in their thinking. They are using the challenge of which staff are willing to work overtime without being paid to determine loyalty to the firm and which staff might be long term employees. Kevin can explain how the paying staff for all hours worked would build greater loyalty to the firm. Staff would see that the firm is committed to the profession, high quality audits, and to their staff. Loyalty builds loyalty.

Caring and empathy are virtues that employees cherish in their bosses.

Although some students may feel this is going too far, Kevin might explain that staff training did not prepare him for the extreme pressures of working within a tight budget and client concerns when that doesn't occur. While not accusing the firm of any impropriety, Kevin might use the leverage that he will improve over time in both speed and efficiency as he gains more confidence on audits. He should show Bo and Moe that he is committed to the job and is hoping to build a long-term career with the firm. This may soften the blow of Kevin not simply rolling over and "eating time."

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71)Sims is trying to counter the arguments that having fraudulent quarterly financial statements to obtain a bank loan does not harm anyone and is okay to do as Leroy is the owner of the company. The stakeholders (employees, bank, other creditors, regulators, and shareholders) of the firm have a right to financial statements that follow GAAP and have adequate disclosures. From a deontology perspective, Marcus Sims should follow the rules of the profession: i.e., GAAP and no subordination of judgment. From a utilitarian perspective all the stakeholders should benefit, not just Leroy the owner. In adjusting the numbers in order to obtain a bank loan, the bank could be greatly harmed in order to benefit one stakeholder, Leroy. If Sims should give into Leroy, then it could be easier to subordinate judgment in the future and may give Leroy the means to blackmail subordination easily.

Leroy and Mayhew might use the reason and rationalization of materiality, although that clearly is not the case - the difference is material in amount. More likely they will tell Sims it is a one-time request (isolated incident) and being a team player is expected at the company (locus of loyalty).

From the facts of the case, we can surmise that Leroy and Mayhew are looking at the short-term goal of obtaining a bank loan versus the longterm effect on reputation. The loan needed from the bank may be considered immaterial in amount but it is material to the continuation of the company's operations. Leroy has already stated that "Do it this one time and I won't ask you to do it again." However, a one-time request to alter the financial statements often turns into an on-going requirement.

The key parties have much at stake. Leroy, Mayhew, and the firm have their reputations for quality manufacturing and corporation citizenship at stake. Sims has his job and reputation as an accountant at stake. Leroy has already mentioned to Sims that he expects loyalty and Sims to go along. Sims is facing going alone with Leroy and being a fall guy when Version 1

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the fraud is uncovered, or losing his job and having a terrible recommendation from Leroy and Cleveland Custom Cabinets as he searches for a new job. The other employees of the firm have the potential of being laid off. The public, bank, creditors, and regulators have an expectation of receiving financial statements and disclosures in accordance with GAAP without fraud or deception. A financial fraud leads to loss of money by investors, creditors, and the public, as well as faith in the free market system.

The integrity of both officers and culture of the company leaves much to be desired. Sims should use the principles of integrity, fairness, and trustworthiness as levers to influence Leroy and Mayhew. He should also use the ethical reasoning of virtues, deontology, rule utilitarianism, enlightened egoism to support his view.

Even though the case is silent whether Sims is a CPA, professional accountants typically hold themselves to high ethical standards such as those in the AICPA Code of Professional Conduct. Sims should explain this to Leroy.

The most powerful and persuasive argument could be that Sims would go to the audit committee and the external auditors to let them know about the altering of the financial statements. Even though Leroy has told Sims not to worry about how they might react, when push comes to shove Leroy might back down especially since it is unlikely to be true that Leroy could simply dismiss the external auditors because Leroy "would take care of them."

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72)The ethical-person organization exchange refers to how the ethics of an individual in an organization fits with the ethics of the organization.

The fit has many implications for building an ethical workplace environment.

Mary Jo Burchard of Regent University explains what she calls "the Ethical Dissonance Model" to illustrate the interaction between the individual and the organization, based on the person-organization ethical fit at various stages of the contractual relationship in each potential ethical fit scenario. This is an important consideration because the ethics of an individual influence the values that one brings to the workplace and decision making, while the ethics (through its culture) of an organization influence that behavior.

Of the four potential fit options, two possess high person-organization fit: (1) high organizational ethics, high individual ethics (High-High), and (2) low organizational ethics, low individual ethics (Low-Low); and two possess low person-organization fit: (1) high organizational ethics, low individual ethics (High-Low) and (2) low organizational ethics, high individual ethics (Low-High).

Imagine that you are working on a project and your boss directs you to do something that you believe is unethical. Maybe it is to fudge the numbers to make the project look more successful than it is. If the organizational fit is Low-High, you have a problem. Your ethical standards are higher than the organization you work for. How will you deal with the dilemma?

In this case we have what is referred to as "ethical dissonance." "Ethical dissonance" is the psychological tension between an employee and the organization when the ethical fit is not a good one. When your standards of behavior differ from the organization's standards, you will feel uncomfortable and torn between doing what you know is the right thing to do as opposed to what may be expected of you by the organization.

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The underlying problem in this case is a difference in values. The individual values honesty while the organization values loyalty. It expects you to be a team player and go along with the fudged numbers.

Given the Low-High fit, you will be under a significant amount of pressure to "take one for the team." However, once you compromise your beliefs, it won't be long before you begin the slide down the proverbial ethical slippery slope.

A reduction in job satisfaction is likely if an employee striving to be ethical perceives little top management support for ethical behavior, an unfavorable ethical climate in the organization, and/or little association between ethical behavior and job success. Once this "ethical dissonance" is discovered, the likelihood of employee turnover rises.

Creating an ethical organization environment is a process that aims to have a High-High fit and one that brings about ethical awareness, expected standards of behavior, and an action plan to ensure the organization's values form the foundation for all decisions. Incorporating the ethical fit into ethics training can help to align organizational and individual goals and motivation for behavior.

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Chapter 3: Organizational Ethics and Corporate Governance MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

1) Organizational ethics can be thought of as A) descriptions of how ethics occurs at a company.

B) principles and standards of behavior that guide business decisions.

C) rules of conduct that establish legal requirements for businesses.

D) standards of reporting ethical violations.

2)

The seven signs of a pending ethical collapse include all but A) fear and silence.

B) strong board of directors.

C) loyalty to the boss.

D) innovation like no other company.

3) All of the following represent potential conflicts of interest described as one of the seven signs of a pending ethical collapse except A) directors having consulting contracts with the company they are directors for.

B) multiple directors serving on both the audit committee and the compensation committee.

C) directors serving on the board for a minimum of 20 years.

D) disclosure in the proxy statements why the board chair and CEO positions are unified.

4) Which of the following represents pressures to maintain the numbers as a sign that an organization has collapsed ethically?

A) Directors have consulting contracts with the company they are directors for.

B) Directors may not serve on more than one committee.

C) Shifting of operating expenses to capitalized costs.

D) The CEO hires only young managers fresh out of college.

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5) Which of the following represents a culture of fear and silence as a sign that an organization has collapsed ethically?

A) kill the messenger syndrome B) directors may not serve on more than one committee C) income increases every quarter D) the CEO hires only friends

6)

The framework of COSO's Enterprise Risk Management can best be characterized as A) incorporate enhanced internal control principles into enhanced corporate governance.

B) incorporate enhanced audit sampling procedures in the testing of internal controls.

C) incorporate enhanced corporate governance into internal control principles.

D) incorporate enhanced audit sampling procedures in substantive testing.

7)

Which of the following is not an element of COSO Enterprise Risk Management?

A) enhancing risk response decisions B) reducing operating surprises and losses C) identification of risks and opportunities affecting achievement of an entity’s objectives D) improving deployment of information technology

8) One of the contributions of the Treadway Commission Report and the work of the Committee of Sponsoring Organizations (COSO) was A) to establish a voluntary process for peer review.

B) to identify red flags that might lead to fraud.

C) to provide a framework for internal control.

D) to establish peer review requirements for CPAs.

9)

Which committee established a framework for internal control?

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A) treadway committee B) cohen committee C) house Subcommittee on Oversight and Investigations D) the audit committee

10)

To establish an ethical corporate culture, organizations do all of the following except A) enforce ethics policies fairly.

B) develop an ethics training program.

C) establish strong internal controls.

D) establish a culture of do what I say, not what I do.

11)

The seven signs of a pending ethical collapse include all but A) pressure to make numbers.

B) whistleblowing hotline.

C) bigger than life CEO. D) conflicts of interest overlooked.

12) In the Pinto case, Ford relied on which approaches to ethical reasoning to decide on a course of action with respect to the faulty gas tank placement A) egoism and utilitarianism.

B) enlightened egoism and rights theory.

C) ethical legalism and utilitarianism.

D) justice and rights theory.

13)

The stakeholder perspective emphasizes the obligations of management to

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A) the shareholders.

B) the shareholders and creditors.

C) all parties impacted by corporate decisions in a significant way.

D) the board of directors.

14)

Which of the following is not an element of an ethical corporate culture?

A) setting a proper tone at the top B) establishing strong internal controls C) having an effective internal audit function D) having an effective external audit

15)

Trust in business is important because

A) management needs to feel confident that employees will carry out organizational objectives.

B) stakeholders need to feel confident that relationships with organizations will be consistent and reliable.

C) stakeholders rely on management to produce shareholder returns.

D) management needs to feel confident that those with relationships with the organization do what they say.

16)

A troubling result of the 2021 Global Business Ethics Survey is A) employees say they work in organizations with a strong ethical culture.

B) decline in pressure to compromise ethics.

C) there is an increase in the likelihood to report wrongdoing.

D) there is a significant increase in retaliation.

17) A common ethical problem where there is an unrealistic expectation to meet expected results and the ends justifies the means can be best described as

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A) pressure to maintain the numbers.

B) fear of reprisal.

C) loyalty to the boss.

D) weak board of directors.

18) Which of the following is least likely to be used by a manager to set the right tone to foster ethical leadership?

A) consider the implications of one's actions on themselves B) make decisions that do not harm others C) make decisions that are universal D) reflect before deciding

19)

A troubling result of the 2013 National Business Ethics Survey is A) decreased witnessing of misconduct in the workplace.

B) decline in pressure to compromise ethics.

C) no change in the likelihood to report misconduct.

D) a high percentage of misconduct is conducted by management.

20)

KPMG’s Integrity Survey 2013 indicates all of the following except

A) nearly three out of four employees reported that they had observed misconduct within their organizations in the previous 12 months.

B) more than half of employees reported that what they observed could potentially cause a significant loss of public trust if discovered.

C) employees were certain that they would be protected from retaliation if they reported concerns to management.

D) ethics and compliance programs continue to have a favorable impact on employee perceptions and behaviors.

21)

Which of the following is not considered a behavioral indicator of fraud?

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A) refusal to take vacations B) satisfaction with pay C) financial difficulties D) an unwillingness to share duties

22)

Fraud can be defined as A) a deliberate misrepresentation to gain an advantage over another party.

B) a cover-up of a mistake made in the financial statements.

C) an error in preparing financial statements.

D) All of the choices are correct.

23)

A unique aspect of occupational fraud is A) the misuse of company assets.

B) the falsification of financial statements.

C) the failure to disclose full and complete information.

D) the failure to resolve conflicts of interest.

24)

The difference between occupational and financial statement fraud is A) occupational fraud is generally committed by employees.

B) occupational fraud is generally committed by external auditors.

C) financial statement fraud occurs either by accident or deliberation.

D) financial statement fraud always starts with non-executive decisions.

25) According to the ACFE 2020 Global Study on Occupational Fraud and Abuse survey, the most common type of occupational fraud scheme is

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A) corruption.

B) fraudulent billing.

C) illegal gratuities.

D) asset misappropriation.

26) The ACFE 2020 Global Study on Occupational Fraud and Abuse found that the most common way that fraud is first detected is A) internal audit.

B) internal controls.

C) external audit.

D) tip.

27) Which of the following was not a finding of the ACFE 2020 Global Study on Occupational Fraud and Abuse?

A) Fraud is more likely to be detected by tips than any other way.

B) Financial statement fraud was the least common type of occupational fraud.

C) Asset misappropriation schemes were the most common type of occupational fraud.

D) External auditors discover about 25 percent of the frauds.

28) Which of the following was the most frequent anti-fraud control identified in the ACFE 2020 Global Study on Occupational Fraud and Abuse Survey?

A) external audit of financial statements B) management certification of financial statements C) internal audit department D) external audit of internal controls over financial reporting

29) According to the ACFE 2020 Global Study on Occupational Fraud and Abuse, which of the following was the most common behavioral indicator of fraud?

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A) living beyond means B) financial difficulties C) addiction problems D) refusal to take vacations

30)

An example of revenue overstatement is A) manipulating reserves.

B) recording gross, rather than net, revenue.

C) reporting cost of sales as a non-operating expense.

D) deferring revenue.

31)

Which of the following is not a fraud method to overstate revenues?

A) recording future sales in the current period B) recording sales of products that are out on consignment C) recording sales based on F.O.B. shipping point D) recording revenues of other companies by acting as a middleman

32)

Examples of improper asset valuation includes all of the following except A) manipulating reserves.

B) changing the useful life of assets.

C) recording sales that never took place.

D) manipulating estimates of fair market value.

33)

Which of the following is not an ethical or legal responsibility of officers and directors?

A) duty of care B) duty of good faith C) duty of loyalty D) duty of fair pay

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34) The level of care expected of a reasonable person under similar circumstances in meeting one's fiduciary duty is called A) duty of loyalty.

B) duty of care.

C) transparency.

D) fairness.

35)

What is the main fiduciary duty of the board of directors?

A) maximize profits for the company B) monitor executive compensation C) safeguard the interests of the corporation and its shareholders D) allow high-risk accounting practices

36)

The business judgment rule refers to A) faithfulness to one's obligations and duties.

B) honesty of purpose and caring.

C) decision making under uncertainty.

D) acting with due care and good faith.

37)

The Clawback rule allows A) protection for whistleblowers from retaliation.

B) recovering compensation from CEOs who engage in financial statement misconduct.

C) compensation for whistleblowers.

D) protections for CEOs who act in good faith.

38) The relationship between the shareholders, directors, and management of a company, as defined by the corporate charter, bylaws, formal policy, and rule of law is known as

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A) code of ethics.

B) corporate leadership.

C) corporate responsibility.

D) corporate governance.

39)

Which of the following is not an element of the corporate governance system?

A) board of directors B) internal controls C) executive compensation policies D) monitoring by top management

40) Corporate governance structures and relationships are shaped by internal and external mechanisms. Which of the following is an external mechanism?

A) state and federal statutes require a baseline corporate governance system B) audit committees must consist of at least three members all of whom are independent of management and the entity C) all directors must be independent of management D) each listed company must have an internal audit function

41) Strong corporate governance relies on a strong board of directors. Which of the following would be a strong candidate to be a board director for XYZ, Incorporated?

A) community member who has already served on the board for 15 years B) investor who has a multi-million-dollar joint venture with the CEO and CFO C) retired controller of a Fortune 500 company D) community member who receives annual large consulting contracts from XYZ

42) Which regulation requires that SEC-registered issuers allow shareholders a separate nonbinding say-on-pay vote regarding the compensation of the company named executive officers?

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A) Sarbanes-Oxley B) COSO Framework C) Dodd-Frank D) Private Securities Litigation Reform Act

43) Under the Sarbanes-Oxley Act, which of the following bodies must contain members that are 100% independent of management?

A) board of directors B) audit committee C) internal auditors D) board of supervisors

44) To ensure audit committee independence, the committee should meet separately with each of the following groups except A) senior executives.

B) internal auditors.

C) external auditors.

D) shareholders.

45)

Which of the following is not one of the audit committee's responsibilities?

A) monitor the integrity of the financial statements B) review all financial reporting judgments C) review whistleblowing and compliance processes D) review and monitor the effectiveness of the external audit process

46) External auditor communications with the audit committee include each of the following except

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A) matters related to why certain accounting policies are considered critical.

B) shareholder returns.

C) significant estimates made by management D) significant unusual transactions

47)

A strong and effective internal control environment can be enhanced by A) financial statements that present fairly financial position and results of operations.

B) giving the internal auditors direct and unrestricted access to the audit committee.

C) having the internal auditors report to the external auditors.

D) having the external auditors report to the audit committee.

48)

Section 302 of the Sarbanes-Oxley Act requires that management A) assess the company's internal controls.

B) certify the financial statements.

C) disclose all executive compensation.

D) blow the whistle on corporate wrongdoing.

49) Which of the following is not a component of an effective internal control environment in COSO Internal Control - Integrated Framework?

A) the control environment B) risk abatement C) control activities D) information and communication

50)

Section 404 of the Sarbanes-Oxley Act requires

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A) the establishment of procedures to accept employee complaints B) the principle executive to certify that they have reviewed the financial statements C) a report of the company’s internal control over financial reporting D) code of ethics requirements for senior officers

51)

Section 301 of the Sarbanes-Oxley Act requires A) the establishment of procedures to accept employee complaints.

B) the principle executive to certify that they have reviewed the financial statements.

C) a report of the company’s internal control over financial reporting.

D) code of ethics requirements for senior officers.

52)

Backdating of stock options is unethical because

A) it favors top executives over other company employees with respect to the number of options.

B) it purposefully manipulates the option criteria that determine their value.

C) it changes the exercise price on options to benefit top executives.

D) it changes the exercise date on options to benefit top executives.

53) Compensation of executives has soared over the last forty plus years to more than 278 times the pay for average workers. Remedies to rein in executive compensation include all but A) say on pay provisions.

B) more diligent board oversight of compensation packages.

C) restrictions by the law as to the maximum total compensation allowable.

D) clawbacks of compensation when it can be shown executives knew of fraud.

54) The ACFE 2020 Global Study on Occupational Fraud and Abuse found that the least common way that fraud is first detected is

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A) IT controls.

B) surveillance.

C) external audit.

D) confession.

55) As a manager in her firm, Lucy concerns herself with the effectiveness of internal controls. Her main focus is how efficient and effective the company's internal controls are over time. Which component of internal control is Lucy engaging in?

A) risk assessment B) control activities C) control environment D) monitoring

56)

Proper tone at the top includes all of the following except A) communicating compliance and ethics messaging to employees.

B) regularly reminding employees of the importance of ethical behavior.

C) rarely enforcing the code of conduct.

D) modeling the company’s values.

57)

The triple bottom line often refers to the three concepts of A) communication, compliance and compassion.

B) risk management, transparency, and profit.

C) people, planet, and profit D) values, productivity, and people

58) Has SOX accomplished its intended goal of reliable financial reporting by public companies?

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A) Yes, as the CEO and CFO are certifying that financial statements contain no material misstatements.

B) Maybe, as very few defendants have been charged with false certification, and fewer still have been convicted.

C) Maybe, as laws are needed but they serve as only a minimum standard of ethical conduct and may not lead to ethical conduct.

D) No, as the SEC has unsuccessfully sought to collect disgorgement of bonuses and other compensations of officers.

59) DeGeorge thinks that "corporations have a moral obligation not to harm." Which of the following would be one of his criteria for morally permitted whistleblowing?

A) Documented evidence exists that would convince a reasonable and impartial observer that one's view of the situation is correct but that serious harm is unlikely to occur.

B) The employee must reasonably believe that going public will not create the necessary change to protect the public and is worth the risk to oneself.

C) The employee should report a firm's actions that will do serious and considerable harm to others to her supervisor, and keep reporting all the way up to board until the actions are corrected.

D) The employee must first report wrongdoing to the external auditor before going public.

60)

Research by Miceli and Near indicates that

A) whistleblowers hope their speaking out achieves the correction of an organization wrongdoing.

B) whistleblowers hope those who violate the rules are prosecuted.

C) whistleblowers are motivated to report under Dodd-Frank to receive an award.

D) whistleblowers always blow the whistle because of altruistic reasons.

61)

What is the significance of the Menendez v Halliburton, Incorporated?

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A) Halliburton was able to preserve and show that their bill and hold method was in accordance with GAAP. B) Menendez was awarded his position back at Halliburton, but the actions of Halliburton were retaliatory.

C) Appeals court panel ruled that Menendez (an internal accountant) had been retaliated against for blowing the whistle.

D) The SEC agreed with Menendez about the bill and hold method; Halliburton restated their financial statements and paid penalties.

62)

With respect to whistleblowing, the Sarbanes-Oxley Act

A) protects employees of publicly traded companies who provide evidence in fraud cases.

B) confers legal protection on managers who reported wrongdoing by top executives.

C) confers legal protection on the board of directors for fraudulent actions by management.

D) protects auditors who blow the whistle to the SEC.

63) The SEC has increased focus on identifying and penalizing misstatements in public company financials. What is one method that the SEC is using to identify companies, CEOs, and CFOs that are misstating financial statements?

A) utilizing the whistleblower provisions of the Dodd-Frank Act to provide a hot line.

B) analyzing patterns of internal control problems even absent a restatement of the financials.

C) analyzing whether the CFO has implemented adequate internal controls and safeguards over the financial reporting function.

D) utilizing the company's ethics code to spot misstatements.

64) The reporting requirements for fraud are detailed in Section 10A of the Securities Exchange Act of 1934. Which of the following steps are not part of a prescribed process that should be followed in deciding whether to report fraud?

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A) determine who is responsible for the fraud.

B) determine whether the violations have a material effect, quantitatively or qualitatively, on the financial statements.

C) determine whether appropriate remedial action has been taken.

D) determine whether reporting to the SEC is necessary.

65) The 2010 Dodd-Frank Act includes additional incentives for whistleblowers. What is the act's effect on whistleblowing by accountants?

A) No accountant, internal or external, whether by job title or certification may receive a reward.

B) All accountants who whistle-blow are protected against retaliation, but may not receive a reward.

C) Internal auditors who whistle-blow may not receive a reward.

D) A CPA may report a violation of a public accounting firm's performance in an audit.

66) Under certain situations, internal accountants are eligible to become Dodd-Frank whistleblowers. Which of the following is not one of those situations?

A) Disclosure to the SEC is needed to prevent "substantial injury" to the financial interest of an entity or its investors.

B) The whistleblower "reasonably believes" the entity is impeding investigation of the misconduct.

C) The whistleblower has first reported the violation internally and at least 120 days have passed with no action.

D) Disclosure to the SEC is needed to prevent "substantial injury" to the audit firm.

67) In the Parable of Sadhu case, Bowen T. McCoy's friend Stephen summed up the dilemma by saying

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A) "I feel that what happened with the sadhu is a good example of the breakdown between ethics in different cultures."

B) "I feel that what happened with the sadhu is a good example of the breakdown between the individual and corporate ethics."

C) "People tend to inevitably act in their own best interest."

D) All of the choices are correct.

68)

What is the ethical issue in the Rite Aid Inventory Surplus Fraud case?

A) The surplus inventory sales and kickback involved collusion between two officers of the company. When Foster wanted to stop the scheme, he was blackmailed into continuing the fraud.

B) Rite-Aid had a comprehensive corporate governance system that complied with all the requirements of Sarbanes-Oxley.

C) The internal auditor found and blew the whistle on the surplus inventory sales and kickback cover-up.

D) Vice Presidents of the company were involved in a material, nine-year surplus inventory sales and kickback scheme.

69)

The primary ethical issue in United Thermostatic Controls is A) misappropriation of corporate assets.

B) accelerating the recording of revenue into an earlier period.

C) delaying the recording of expenses into a later period.

D) failure to fully disclose all information.

70)

The key fraud issue in the Franklin Industries Whistleblowing Case is A) fraudulent financial statements were covered-up.

B) corporate culture pressured an employee to go along with fraud.

C) retaliation for reporting an embezzlement fraud.

D) recording revenues too soon led to fraudulent statements.

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71)

What was the primary ethical issue in the Franklin Industries case?

A) inventory shrinkage doubled year-over-year B) retaliation for reporting a sexual harassment C) embezzlement of company funds D) improper accounting classification of marketable securities

72)

The Full Disclosure: The Case of a Morally Challenged AP clerk involves the issue of A) embezzling money by processing fictitious invoices.

B) lowering the rate of rebates to increase operating income.

C) falsifying utility rates to decrease expenses.

D) lowering the rate of return on utility sales.

73)

What was the primary ethical issue in the Theranos case?

A) cultural differences between U.S. and non-U.S. companies B) retaliation for reporting misconduct C) misrepresentations to potential investors D) improper accounting classification of leases

74) What non GAAP accounting method did Tony Menendez cite in blowing the whistle on Halliburton?

A) recording sales that lack economic substance B) failing to write off impaired assets C) bill and hold revenue recognition D) releasing cookie jar reserves to smooth income

75)

In the Wells Fargo case, what is the primary ethical issue?

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A) recording sales that lack economic substance B) aggressive sales tactics and charging for services not requested C) bill and hold revenue recognition D) releasing cookie jar reserves to smooth income

76)

All of the following are systematic failures in the Wells Fargo case except A) a failure of leadership.

B) creating a toxic culture.

C) not living up to the standards in its ethics code.

D) processing employee reports of fraudulent accounts.

ESSAY. Write your answer in the space provided or on a separate sheet of paper.

77) Analyze the reaction of Toyota from an ethical perspective to disclosures that occurred in late 2009 and early 2010 that the accelerator in some brands might get stuck and result in unintended acceleration of the car. How does Toyota's reaction relate to that of Ford with the Pinto and Johnson & Johnson with the Tylenol poisoning?

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78) In September 2015, Volkswagen disclosed it had sold hundreds of thousands of diesel cars in the U.S. with software specifically designed to evade government pollution tests. The company disclosed that the irregularities on diesel-emission readings extend to some 11 million vehicles globally. The company has admitted that it rigged diesel vehicles using a "defeat device" to pass lab tests, even though they emitted as much as 40 times the legal limit of pollutants on the road.

In November 2015, VW set a November 30 deadline for staff with knowledge about its diesel emissions test cheating to come forward. Workers who get in touch with internal investigators by then would be exempt from dismissal. VW said it would not sack workers for what they might reveal, but they might be transferred to other duties. "Employees covered by collective bargaining agreements who get in touch promptly, but no later than November 30, 2015.. and.. may rest assured that the company will waive consequences under labor law such as the termination of employment, and will not make any claim for damages," according to the letter sent to workers.Evaluate VW's actions from an ethical perspective.

Evaluate VW's actions from an ethical perspective.

79) Tommy Hubbs is the new controller of XYZ Corporation. Recently, Hubbs was approached by Carol Franks, the CFO, and told in no uncertain terms to record $100,000 in revenue at the end of 2021 even though the sale was not made until January 3, 2022. Describe Hubbs's ethical responsibilities in this matter if he is a CPA?

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80) Tommy Hubbs is the new controller of XYZ Corporation. Recently, Hubbs was approached by Carol Franks, the CFO, and told in no uncertain terms to record $100,000 in revenue at the end of 2021 even though the sale was not made until January 3, 2022. Hubbs contacts a good friend who used to be the controller of XYZ and is told the environment of the company is one of loyalty at all costs. His friend shares that he left the company because of differences on numerous accounting issues. The friend advises Hubbs to let it go this one time to show he is a team player.

Assume Hubbs decides not to go along with Franks' dictum. Prepare an outline to help him give voice to his values and attempt to change hearts and minds of those in XYZ that might block proper accounting.

Use the following to guide students on what is expected of them in answering this question.

As you read the case, think about the following series of questions for the protagonist to address after identifying the right thing to do including: • How can they get it done effectively and efficiently? • What do they need to say, to whom, and in what sequence? • What will the objections or push-back be and, then? • What would they say next? What data and examples do they need?

81)

Is whistleblowing a moral practice? How might you evaluate whether it is or is not?

82) What causes auditors to make unethical decisions? Are these factors different across different types of auditors?

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83)

Identify the seven signs of a pending ethical collapse.

84) An Internet Company has a chance to expand its business into a developing country. This opportunity if executed would make money for the shareholders, as it would be the first Internet Company allowed in the country. However, the conditions demanded by the country include that the company must turn over to the government the history of Internet sites visited by its citizens.

Additionally, the Internet Company must also censor Internet sites requested through the search engine. In the United States and other countries, the Internet Company would not monitor, censor, or turn over a history of Internet sites to any government.

What should the Internet Company do? Use ethical theories and ethical decision making model to back up your decision.

85) Lana is a CPA and works as an internal auditor for Dynamite, Inc. As she was performing a revenue timing test, for the internal audit schedule and the external auditors, she noticed that the Western division consistently kept the books open 4 days into the next quarter. Lana immediately reported to the Chief Internal Auditor; together they took the issue to the CFO and Controller. The CFO assured them that the issue would be resolved. It has been 90 days since the meeting. Lana is considering blowing the whistle but cannot decide who to tell and when.

What are the ethical issues of concern for Lana? What would you advise Lana to do, how, to whom, and in what order, assuming she could qualify for a reward under Dodd-Frank?

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86) Kyle and Luis were friends since rooming together in college ten years ago. They were both finance and accounting double majors. They were each other's weddings and their wives were also good friends. After college Kyle went on to get his CPA license and ultimately went to work as controller, and then CFO, of a publicly held hardware chain, King's Hardware. King's had twenty-five retail outlets in a five state region and looking at acquiring a hardware chain (Rex's) of six retail outlets in a state that King's wants to get a presence in. Luis worked for a bank after college but then changed to being a real estate investor. Luis was the one who gave Kyle the tip on Rex's being open to a takeover offer; Luis was the realtor for all of Rex's store locations.

Kyle hired a CPA firm to do due diligence for the acquisition, including updated appraisals of Rex's store locations and valuations of contents of each store. Kyle had the report. The problem was that the report is showing that Luis was a 10% owner of Rex's; would be paid a 15% commission by Rex's upon a successful buy-out; and, most troubling of all, the value of Rex's locations and inventory was overstated on Rex's books by 50%.

87) Imagine you just went to your local pharmacy and were told that the cost of a life-saving drug was $22,500 for 30 tablets to treat AIDS or another infectious disease. Well, if you needed the drug Daraprim that is what you would have to pay according to the CEO of the company that manufactured it. Turing Pharmaceuticals purchased the right to Daraprim in August 2015 and CEO Martin Shkreli decided a price increase of 5500% was needed. Evaluate the ethics and corporate responsibility in Shkreli's decision to charge the $22,500 for 30 tablets.

88)

Explain how an ethical workplace culture can be best established.

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Answer Key Test name: Chap 03_6e_ Mintz 1) B 2) B 3) D 4) C 5) B 6) C 7) D 8) C 9) A 10) D 11) B 12) C 13) C 14) D 15) B 16) D 17) A 18) B 19) D 20) C 21) B 22) A 23) A 24) A 25) D 26) D Version 1

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27) D 28) A 29) A 30) B 31) C 32) C 33) D 34) B 35) C 36) D 37) B 38) D 39) D 40) A 41) C 42) C 43) B 44) D 45) B 46) B 47) B 48) B 49) B 50) C 51) A 52) B 53) C 54) D 55) D 56) C Version 1

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57) C 58) C 59) C 60) A 61) C 62) A 63) B 64) A 65) D 66) D 67) B 68) D 69) B 70) C 71) C 72) A 73) C 74) C 75) B 76) D

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77)A review of the Ford Pinto situation is as follows: The Ford Pinto experienced fires easily in rear-end collisions with the gas tanks being right behind the license plate. Ford did a risk-benefit analysis to aid decision making. Ford relied on ethical legalism to justify and rationalize its actions. Ford used act-utilitarian reasoning that focused only on costs and benefits and ignored rights of the various stakeholders.

A rule-utilitarianism or rights theory approach might have led Ford to follow a rule of not sacrificing public safety or that the public had a right to expect that cars will not blow up if there is a rear collision at low speeds.

The Lexus situation parallels the Ford Pinto. Toyota and the Lexus brands have acceleration problems and complaints for over 20 years, since 1993. The firm first blamed the problems on the drivers. As the number of complaints and injuries grew, the company did cost analysis and decided to limit the number of vehicles to be serviced to those who complained and to limit costs on a per-car basis. The problems at Lexus and Toyota came as more automakers entered the international markets.

Toyota was beginning to lose the quality advantage as both international and U.S. automakers focused more on quality, not just style.

The Lexus acceleration problem seems to show a moral blindness and group-think on the part of Toyota. The firm may have felt pressure to maintain leadership and quality in the auto market. It is interesting to note that in the U.S. such moral blindness tends to be associated with management and often out of greed for personal incentive pay. With Lexus, it seemed to be for the benefit of the firm and quality leadership.

This probably reflects different cultural values. In Hofstede's study of cultural variables that was discussed in chapter 1, the score on individualism was 46, reflecting a greater emphasis on the collective good. In the U.S. the individualism score was 91, reflecting an emphasis on individual effort and responsibility. For Toyota, the moral blindness Version 1

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led to ignoring product defect information and then when it was discovered doing a similar cost analysis as was done in the Ford Pinto case.

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78)Clearly, Volkswagen acted in an egoistic manner much like Ford, GM, and Toyota in other auto product defect cases discussed.

A key issue is what did management know and when did it know it. Any attempt to cover-up a fraud is a violation of the law and subjects VW to prosecution in the U.S., not to mention a loss of reputation and probably future sales of autos both within and outside the U.S. An internal review spurred by the emissions scandal determined that the carmaker knew that so-called "defeat devices," used to trick emissions tests, were used in more than 11 million VW and 2.1 million Audi diesel vehicles for several years before the Environmental Protection Agency issued a violation notice to the manufacturer ordering it to recall some 500,000 sedans.

The Associated Press, citing two German publications, reported in September 2015 that VW's internal investigation has so far found at least two incidents in which VW was made aware that the use of defeat devices were against the law.

The Frankfurter Allgemeine Sonntagszeitung, a German publication, reported that VW's internal investigation shows one of the company's own technicians was aware of the software. Back in 2011, an engineer reportedly expressed concern that using the device was illegal, but was ignored.

The same investigation turned up a letter, dated 2007, from parts supplier Bosch that warned the car company not to use the software during regular operations of vehicles.

According to Bild am Sonntag, sources uncovered the internal communications between Bosch and VW, with the parts supplier insisting that the software was for test purposes and that using it in regular operation would be against the law.

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evade emissions standards for certain pollutants with a range of serious health effects.

According to the EPA's order, the "sophisticated software algorithm" in the vehicles is programmed to detect when the car is undergoing official emissions testing, and to only turn on full emissions control systems during that testing. However, the effectiveness of these vehicles' pollution emissions control devices is greatly reduced during all normal driving situations.

In addition to new revelations that VW was aware that the defeat devices were illegal, CNBC reported that the company's now former CEO Martin Winterkorn is under criminal investigation by German prosecutors related to fraud. He stepped down shortly after the disclosure of the embarrassing event noting that he took full responsibility for irregularities in nearly 11 million diesel vehicles found to contain "defeat devices," the former CEO is at the center of the latest investigation into the manufacturer.

The company is not disputing any of the charges. In fact, Winterkorn said that his company is "deeply sorry" for the emissions-cheating scandal and will do everything necessary in order to reverse the damage this has caused. "Our company was dishonest with the EPA, and the California Air Resources Board, and with all of you. And in my German words: We have totally screwed up." Unfortunately, Winterkorn then turned around and undid all the good by apologizing when he qualified it by saying that he had personally committed no misconduct. "I am not aware of any wrongdoing on my part," he said. This shows a lack of ethical commitment to the wrongdoing: he really didn't own the problem.

(Source: http://consumerist.com/2015/09/28/report-volkswagen-knewof-defeat-devices-eight-years-before-epa-action/).

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needs to stop the bleeding not only with respect to the widening scandal itself but to reverse the trend of declining sales of its cars. Hence the amnesty for whistleblowers. Any concerted effort to deceive regulators would have needed input from engineers and technicians. They may have valuable knowledge to share, which could speed up the process dramatically. The offer does not apply to managers. So if it turns out that deception was authorized at a high level, those responsible can still expect to be punished.

To set a deadline on by when a would-be whistle-blower must come forward to be protected against retaliation minimizes the cheating event and attempts to stifle dissent and transparency. Germany has a relatively high score on Uncertainty Avoidance (65) compared to the U.S. score (46). This helps to explain why they want the matter to be kept as secret as possible and rush through the reporting process by those in the know.

It appears the government is more concerned with stifling dissent than taking the whole matter to heart and using it as a way to change the culture of corporations in Germany with respect to secrecy.

VW is also hoping to limit the monetary damages by paying over $500 to VW car owners hit by its emissions cheating scandal. "Affected customers eligible for the goodwill package are not required to sign a release.. in order to receive the package," said VW spokeswoman Jeannine Ginivan. As if the customers would sign such an agreement in the first place.

But for many owners, the gesture is too little, too late.

"I personally feel insulted by their peace offering," said Nevada resident Dave Thompson, who owns a 2010 diesel Jetta sportswagon. He said buyers paid a $5,000 premium to get the diesel engine and the better fuel economy with the promise that it was also good for the environment.

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in the face" and "scandalous" to describe the apologetic payout, which will come in the form of a gift card that can be used anywhere. Diesel owners will also get another card worth $500 that can be spent only on purchases or services at VW or Audi dealerships, as well as free 24-hour roadside assistance for the next three years.

So, what does VW say in its defense? "We are providing this goodwill package as a first step towards regaining our customers' trust," said Michael Horn, the head of VW's U.S. operations. Good luck with that.

VW said in September it had set aside $7.3 billion to deal with fixing the problem, which caused the company to report a third quarter loss. At this early stage, putting a precise price tag on the ultimate cost of pollution penalties, criminal fines, private settlements, and the like is virtually impossible. We've heard an $18 billion liability figure reflects the maximum per-car clean-air penalty the Environmental Protection Agency could, in theory, assess. That's a huge amount. However, it's not enough, in my view, because this is a case where intent to deceive is easy to establish making it a slam dunk for fraud. In fact, early reports indicate that the German government may have known that VW was rigging its emissions tests.

The VW story is one of corporate misconduct at the highest levels. In a country where corporate social responsibility is supposed to be a mantra for corporate behavior, VW has proven once again the old adage that do what I say, not what I do is alive and well and living in Wolfsburg, Germany.

The following is a link to two blogs written by Steven Mintz that can help to extend the discussion. http://www.ethicssage.com/2015/09/vws-irresponsible-behavior-hasconsequences.html http://www.workplaceethicsadvice.com/2015/11/volkswagen-pollutesworkplace-ethics.html Version 1

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79)Hubbs's ethical responsibilities as a CPA is first to the public interest.

Ethical standards require that Hubbs act with objectivity and integrity.

Under Interpretation 102-4 (Exhibit 3.13), he should report the wrongdoing to the CEO and make every effort to correct the matter. If nothing changes, then Hubbs would follow the prescribed procedures under Section 10A of the Securities Exchange Act of 1934 and do the following: 1. Determine whether the violations have a material effect, quantitatively or qualitatively, on the financial statements.

2. If yes, has management, or the board of directors, caused management to take remedial action, including reporting externally if necessary?

3. If no, then the auditor must make a formal report of its conclusions and provide the report to the board of directors. The board then has one business day to inform the SEC and provide a copy of the communication to the external auditor.

If the auditing firm does not receive a copy within one business day, then it has two chose: 1. Provide a copy of its own report to the SEC within one business day, or 2. Resign from the engagement and provide a copy of the report to the SEC within one business day of resigning.

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80)To assist you in the process of analyzing what actions should be taken by the protagonist, here are the most frequent categories of argument or rationalization that we face when we speak out against unethical practice.

Expected or Standard Practice: "Everyone does this, so it's really standard practice. It's even expected."

Materiality: "The impact of this action is not material. It doesn't really hurt anyone."

Locus of Responsibility: "This is not my responsibility; I'm just following orders here."

Locus of Loyalty: "I know this isn't quite fair to the stakeholders, but I don't want to hurt my reports/team/boss/company."

Isolated Incident: "This is a one-time request; you won't be asked to do it again."

After the discussion is completed, ask students if they would be willing to blow the whistle by going to the SEC if they are unsuccessful.

General Guidance: Hubbs should follow the process outlined in Exhibit 3.13 and described in question #3. This should include bringing the matter to the attention of the board of directors, if necessary.

Hubbs should look for supporters in the organization. He might contact a member of the board prior to going to the board if he knows that person well and/or has established a relationship with that party. This is step Cynthia Cooper took in the WorldCom fraud when she approached the chair of the audit committee.

Hubbs needs to counteract the reasons and rationalizations by using the lever of professional responsibilities and that the company is becoming involved in a fraudulent activity that will only result negative consequences in the long run.

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accelerating the revenue into 2015, the company is borrowing from the future to make the current operating results look better and will need to find ways to cover the shortfall at the end of 2016. He should explain it becomes a snowball effect that falls apart down the road.

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81)A broad view of whistleblowing is the disclosure by organization members (former or current) of illegal, immoral, or illegitimate practices under the control of their employers, to persons or organizations that may be able to effect action. This definition includes whistle-blowers who use internal channels (e.g., a hot line or ombudsperson) or external channels (e.g., the external auditors or the SEC) to blow the whistle.

There are four elements of the whistleblowing process: the whistleblower, the whistleblowing act or complaint, the party to whom the complaint is made, and the organization against which the complaint is lodged. The act might be labeled as one of "dissidence," somewhat analogous to civil disobedience. It may be seen as disloyal by some but in the public interest by others.

Given that the act of whistleblowing is a personal choice, the key to whether an individual will blow the whistle on wrongdoing is whether the whistle-blower perceives organizational policies are designed to encourage moral autonomy, individual responsibility, and organizational support for whistle-blowers.

Moral agency is important for the determination of moral behavior and it enables the moral evaluation of the agent's behavior. The basic characteristic of the philosophical concept of moral agency is autonomy and is viewed in the context of the ability or will to be one's own person.

Autonomy plays an important role in conceptions of moral obligation and responsibility.

Autonomous will means to act according to reasons and motives that are taken as one's own and not the product of organizational policies and external forces such as whistleblowing legislation. Autonomous will is the central value in the Kantian tradition of moral philosophy that moral requirements are based on the standard of rationality he called the "Categorical Imperative."

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moral law that applies to all rational beings and is independent of any personal motive or desire. Therefore, we could say that even if pressure exists in an organization to not report wrongdoing, a rational, moral person will withstand such pressure, regardless of perceived retaliation, because it is a moral requirement to do so. Kant argued that conformity to the Categorical Imperative, and hence to moral requirements themselves, is essential to rational agency.

Researchers have posed the question of whether workplace whistleblowing is a right, and thus allows for responsible behavior, or whether it is an imposed corporate duty thus resulting in liability of workers. If an organization institutes an internal whistleblowing policy, it is because it perceives moral autonomy to be weak. When businesses then implement the policy, it leads to the conclusion that moral autonomy is strong, and employees are expected to blow the whistle.

Therefore, if employees do not blow the whistle in accordance with corporate policy they then become liable for not doing so, rendering the policy a tool that controls employee behavior. Responsibility for misdeeds then shifts from the organization to the individual and employees are further stripped of the right to moral autonomy.

Research has shown that what whistleblowers hope and believe their speaking out will achieve, is the correction of what they perceive as an organizational wrongdoing (e.g., fraudulent financial statements). This research also found that not everyone who perceives a wrongdoing, acts upon that perception. In fact, only 42 percent stated they were ready to blow the whistle.

Those who observe wrongdoing but would not do so identify a "retaliatory climate" in their organizations as the primary barrier to blowing the whistle on corporate wrongdoing while those who say they would speak up about it, were confident that they "would not experience managerial retaliation if they blew the whistle." The National Business Version 1

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Ethics Survey found that 46 percent of employees did not blow the whistle for fear of retaliation while 21 percent that reported misconduct said they faced some form of retribution (ERC 2013).

Whistleblowing regulations attempt to protect individuals when they behave responsibly towards society in light of irresponsible behavior by their organizations. This certainly is the motivation for the antiretaliation provisions of both the Sarbanes-Oxley Act and the DoddFrank Financial Reform Act. The acknowledgement of the need for such protection, however, implies that moral agency, autonomy and responsibility are problematic in organizations, or at the very least, that they do not come naturally and are not welcomed when they arrive.

When organizations establish an ethical culture and anonymous channels to report wrongdoing, they create an environment that supports whistleblowing and whistle-blowers while controlling for possible retaliation.

Whistleblowing always involves an actual or at least declared intention to prevent something bad that would otherwise occur. It always involves information that would not ordinarily be revealed. Most ethicists agree whistleblowing is an ethical action. According to the "standard theory" on whistleblowing, whistleblowing is morally required when it is required at all; people have a moral obligation to prevent serious harm to others if they can do so with little costs to themselves.

The morality of whistleblowing might be viewed from the perspective that corporations have a moral obligation not to harm. De George identifies five criteria when whistleblowing is morally permitted.

Briefly, (1) the firm's actions will do serious and considerable harm to others; (2) the whistleblowing act is justifiable once the employee reports it to her immediate supervisor and makes her moral concerns known; (3) absent any action by the supervisor, the employee should take the matter all the way up to the board, if necessary; (4) documented Version 1

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evidence must exist that would convince a reasonable and impartial observer that one's views of the situation is correct and that serious harm may occur; and (5) the employee must reasonably believe that going public will create the necessary change to protect the public and is worth the risk to oneself.

De George's criteria establish the foundation for moral behavior to occur when contemplating whistleblowing. He rejects the position that external whistleblowing is always morally justifiable, and also rejects the position that external whistleblowing is never morally justifiable.

Basically his position is that the whistleblower should have a moral motivation to engage in the act (i.e., to expose unnecessary harm, and illegal or immoral actions).

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82)Auditors tend to be highly ethical individuals. They choose the audit road because they recognize the importance of serving the public interest. They are aware of their ethical obligations and gladly accept them as integral to providing a public service.

In reality, ethical pressures arise for both internal and external auditors that test their commitment to doing the right thing. While the individual auditor may be ethical, it does not mean that the organization has an ethical culture. In companies with strong ethical cultures, dissonance is reduced while in organizations with weak ethical cultures the ethical dissonance between the high ethics of an individual auditor and top management creates added pressures that may make it difficult to act on one's values. In such cases the internal auditor needs to find a way to counteract the reasons and rationalizations given internally to deviate from ethical norms.

For external auditors, the pressures come from clients that want to put the best face possible on the financial statements rather than report financial results in accordance with GAAP. Top management pressures CPA firm management and threatens to take their audit business elsewhere, and that might also mean no lucrative nonaudit services.

Here, the firm's own quality controls should help to counteract the reasons and rationalizations of a self-interested client and support ethical behavior by the auditors.

Extended Discussion Donald Arnold Sr., Jack Dorminey, A. A. Neidermeyer, and Presha Neidermeyer attempted to answer these questions by surveying internal auditors working for publicly traded U.S. businesses and external auditors at the Big Four public accounting firms and smaller regional and local firms. "Internal and External Auditor Ethical DecisionMaking," published in the Managerial Auditing Journal (Vol. 28 (2013), Issue 4), sheds light on the ethical decision-making processes of internal Version 1

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and external auditors. The work is one of the first studies to compare internal and external auditors and to look not only at Big Four auditors but also external auditors from smaller, regional firms.

While internal and external auditors share a similar set of audit principles and ethical standards, they differ significantly in terms of the structure and size of the organizations for which they work, their training, to whom they report, and the type of services they provide.

These differences could translate into different ways auditors consider and respond to ethical concerns. The study examined how two situational factors—social consensus and magnitude of consequences— affect an auditor's ethical decision-making.

By statistically analyzing the survey responses, the research revealed that the magnitude of consequences to victims of the action in question does not influence the ethical decision-making of internal or external auditors differently. However, the authors found that the effect of social consensus (the degree of agreement that an act is right or wrong) on ethical decision-making differs among the various groups of auditors.

Specifically, social consensus explains in large part how auditors of Big Four firms intend to act when faced with an ethical dilemma. However, for small firm and internal auditors, this effect is not as strong. The authors suggested that the more diverse and political environments in which the larger firms operate make auditors of Big Four firms more cognizant of aligning their views with social norms. Thus, social consensus may be more critical among this group of auditors.

The study's findings showed that the auditors' ethical decision-making process is contingent on the situational context. Differences among internal, large-firm external, and small-firm external auditors on social consensus lead to differences in the ethical decision-making processes for these three types of auditors. Consequently, the authors urged the profession and policymakers to consider how these differences should be Version 1

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addressed in individual firm policies as well as in the ethical training that different groups of auditors should receive.

(Source: http://www.journalofaccountancy.com/issues/2014/jun/20139009.html#s thash.Q7YC8BQ4.dpuf).

83)In her book The Seven Signs of Ethical Collapse, Marianne Jennings analyzes the indicators of possible ethical collapse in companies and provides advice on how to avoid impending disaster. According to Jennings, “When an organization collapses ethically, it means that those in the organization have drifted into rationalizations and legalisms, and all for the purpose of getting the results they want and need at almost any cost.

Jennings links the rationalizations and legalisms to a culture that leads to behavior based on the notion “It’s not a question of should we do it.” It is a culture of “Can we do it legally?” This mentality occurs because of the combination of the seven factors working together to cloud judgment.

Jennings identifies the seven signs of a pending ethical collapse as (1) pressure to maintain numbers; (2) fear and silence; (3) young ’uns and a bigger-than-life CEO (i.e., loyalty to the boss); (4) weak board of directors; (5) conflicts of interest overlooked or unaddressed; (6) innovation like no other company; and (7) goodness in some areas atones for evil in others.

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84)The Company is faced with the decision of whether to treat citizens in one country differently than citizens in other countries. This is a troubling issue since it applies to the right to privacy of the citizens. The Company is also faced with whether their primary obligation is to make profits for shareholders per Milton Friedman or per another ethical theory. In looking at the different ethical theories, rights approach would say if one country's citizens are entitled to privacy, then another country's would also. Deontology would also say that the imperative "Universality" would require citizens of all countries to be treated the same. Utilitarianism would say that the end justifies the mean so that the company would have to decide if the end was profits or treating all citizens of the world the same.

Extended Discussion China, long known for its strict Internet censorship laws, is now sending online censors to take posts at the country's biggest online companies.

Key "network security officers" will monitor the work of key websites and Web firms for crimes such as fraud and the "spreading of rumors," according to China's Ministry of Public Security. These officers would be a part of the roughly 2 million people employed by the government to monitor Web activity.

Of the three biggest Internet companies in China—retail giant Alibaba, messaging company Tencent and search-engine service provider Baidu— only Alibaba has issued a statement to saying it will work withChinese authorities to combat illegal and criminal activities on the Internet.

The new policy marks China's latest attempt at censoring the world's Internet users; the country is home to almost 22% of the world's total Web population. Around 18,930 websites are reportedly blocked by China's notorious "Great Firewall," a list that include popular sites and Web services such as Twitter, Facebook, Gmail, The New York Times,

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YouTube, and Instagram.

85)First, Lana does have a confidentiality requirement to her employer, Dynamite, Incorporated. She needs to consider that any disclosure of the event outside the company raises ethical questions. However, Lana would be protected against any ethics violations if she reports under Dodd-Frank because the confidentiality obligation is waived when regulatory requirements sanction such reporting. Dodd-Frank does so to protect the public interest above all else.

Under Section 10A of the Securities Exchange Act of 1934, Lana should: ● Determine whether the violations have a material effect, quantitatively or qualitatively, on the financial statements. ● If yes, has management, or the board of directors, caused management to take remedial action, including reporting externally, if necessary? ● If no, then the individual must make a formal report of the issue with conclusions on the effect and provide the report to the board of directors.

Lana should complete any of the above steps that has not yet been done.

Having done the above steps, then Lana will have first reported the violation internally. She will need to wait another 30 days (or a total of 120 days) before going to the SEC. She will also have to believe that the disclosure is necessary to prevent substantial injury to the financial interest of an entity or its investors and reasonably believes the entity is impeding investigation of the misconduct.

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86)Kyle is considering who to tell, how, when. Most of all he is feeling betrayed by Luis.

1. What are the ethical issues?

2. What would you do next and why? Consider the following in your response. ● What do you need to say, to whom, and in what sequence? ● What are the reasons and rationalizations you are likely to hear from those who would try to detract you from your goal? ● How can you counteract those pressures? What is your powerful and persuasive response to these arguments? To whom should you make them? When and in what context?

The ethical issues are the overvaluation of Rex's store locations and valuations of inventory; whether to counteroffer on the buy-out or to decline to buy Rex's, and whether to let Luis know what was discovered in getting the appraisals. This case has an interesting twist in that the one who involved in the fraud is his good friend from college. Students may suggest that Kyle talks to Luis first and find out why and what Luis is doing. However, Kyle has a loyal obligation to discharge his work obligations first and then talk to his friend.

Kyle needs to let the CEO, audit committee and the board of directors know about the appraisals, give the options, and give his suggested best option. The case does not make clear if Rex's knows about Luis's conflict of interests or the overvaluation of properties and inventory.

Kyle may want to prepare before he talks to Luis. He will want to anticipate Luis's reasons and rationalizations. Luis may have a reason for trying to amass a lot of money. Kyle will need to remind Luis of the values they discussed in college and how integrity is a key ethical standard in accounting.

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of Responsibility: Kyle had no part in Luis' decisions and should play no role in telling him what to do or not to do. This may be a situation where Kyle turns to a trusted friend or advisor for guidance on how best to handle the matter and apparent conflict of interest. Kyle is a CPA and must follow the rules of conduct including objectivity and integrity. He cannot ignore the matter or fail to inform his superiors out of friendship with Luis.

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87)An increase from $13.50 per dose to $750.00 per pill is unconscionable. Pharmaceutical companies have a right to make a profit but when they throw the consuming public under the bus and engage in price gouging, the company has gone too far. Shkreli's decision was obviously motivated by greed. He raised the price because he could do it and realized he had a captive market for the drug. There appears to have been no corporate governance mechanisms to keep in check what is gross greed.

Companies have a responsibility to serve the public just as do CPAs in their performance of professional responsibilities. The primary difference is CPAs in their work are not primarily motivated by profit, although the desire to keep clients happy and earn as much revenue as possible is a powerful motivation that might lead to unethical decisions.

However, these decisions are not designed to harm others.

We can blame, at least in part, drug price increases on overpaid CEOs of Big-Pharma who look to satisfy their own self-interest first and that of their companies, and relegate corporate social responsibility and public health issues to the back of the bus.

There seems to be no easy answer to the growing problem of high drug prices. We can't expect CEOs to control their own compensation. The agency problem is real and agency costs are high to control unethical behaviors of some CEOs. Laws are in place to protect the public including Sarbanes-Oxley that has established many internal control and corporate governance provisions to protect the public.

To be fair, there is some rationale for the positions of big Pharma CEOs that high drug prices are needed because the cost of research and development of new, more advanced medications is ever-increasing.

With an aging population, the need to fight off diseases that can be lifethreatening is acute.

The bottom line comes from the movie, Wall Street. "Greed is good.

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Greed is right. Greed works." These are the words spoken by Gordon Gekko in Wall Street. We could say this is the mantra of greedy CEOs of pharmaceutical companies. In a 2014 survey by Fierce Pharma, a news outlet for the industry, the average pay of the 10 top CEOs of big Pharma was about $30 million. None of the companies were in the Fortune top 100. Celgene was number 369, the highest in the industry.

The CEO of Celgene earned $36.61 million. This seems out of line given the relatively small size of most pharmaceutical manufacturing companies.

Extended Discussion So, what can be done about the extraordinarily high prices of medications? Economic guru Jared Bernstein, a senior fellow at the Center on Budget and Policy Priorities, believes creative solutions are needed and suggests a new way to reward originality in drug research and development by offering a generous cash prize for inventing new medicines, and growing the National Institutes of Health to subsidize the expensive stages of early research for pharmaceutical companies. We are skeptical of Bernstein's plan because it, too, provides a greater role for government in prescription drug policy.

A group of 118 oncologists came out in an editorial in the Mayo Clinic medical journal to support a grassroots patient effort to push for fairer prices from drug companies. According to the editorial, many cancer patients are bankrupted by the high cost of care even for insured patients for treatment that costs $120,000 a year. The proposal is to get it down to $30,000 in out-of-pocket expenses—more than half the average U.S. household income. According to the editorial, the drugs are so high that as many as 20% of oncology patients don't take their medication as prescribed.

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88)Corporate culture is the shared beliefs of top managers in a company about how they should manage themselves and other employees, and how they should conduct their business. An important element of ethical culture is the tone at the top. Tone at the top refers to the ethical environment that is created in the workplace by the organization's leadership. An ethical tone creates the basis for standards of behavior that become part of the code of ethics.

The tone set by managers influences how employees respond to ethical challenges and is enhanced by ethical leadership. When leaders are perceived as trustworthy, employee trust increases; leaders are seen as ethical and as honoring a higher level of duties. Employees identify with the organization's values and the likely outcome is high individual ethics; high organization ethics; and a lack of dissonance.

If the tone set by management upholds ethics and integrity, employees will be more inclined to uphold those same values. However, if top management appears unconcerned about ethics and focuses solely on the bottom line, employees will be more prone to commit fraud, whether occupational (i.e., job-related), or participation in fraudulent financial reporting as occurred with Betty Vinson.

Corporate culture starts with an explicit statement of values, beliefs, and customs from top management. A code of ethics serves as a guide to support ethical decision making. It clarifies an organization's mission, values, and principles, linking them with standards of professional conduct.

Setting up an ethical workplace culture is more involved than drafting a values statement, setting policy or training programs ensure employees and vendors are knowledgeable about the rules. Ethical workplace cultures are ones that make it far easier to do the right thing and much harder to do the wrong thing. Unfortunately, the problem is many business cultures make it easier to make the wrong decisions and harder Version 1

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to take the ethical approach.

For a company to establish an ethical culture they need to know what this would look like in their workplace, and then as Stephen Covey says, "Start with the end in mind." Next establish an atmosphere, reinforced by both formal and informal incentives processes in the company, which promotes the values that result in conduct deemed to be ethical. A good example is the Six Pillars of Character: trustworthiness, respect, responsibility, fairness, caring and citizenship.

How does a business instill these values in their company culture? First a business needs to be conscious about who is being recruited and how employees and vendors are being incentivized. It is more difficult to bring in new people with less than ideal values and change them to be in-line with the company's values then hire for character and train for skills. The ethical dissonance creates a problem that unless a socialization effect diffuses the dissonance, it will create conflict until the company either alters its ethical standards or the employee changes behavior to conform to company norms.

When looking at candidates a business needs to understand that most people have the capacity, willingness and desire to be ethical but many people also have the great desire to succeed that is so strong that they are willing to sacrifice their ethics to accomplish success. So, when recruiting and interviewing it is important to convey that in order to succeed in this company we expect these values. To say this and not back it up is just hypocrisy and what you allow you encourage. If a business is going to make a point to state that it important for their employees and vendors to display certain ethical values, then something negative needs to happen when people do not display these values.

There have to be consequences for unethical behavior. These consequences must be fairly, but strictly enforced to establish an ethical culture.

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The company has to say their values, believe in them, and back them up.

The Josephson Institute of Ethics calls it T.E.A.M., which stands for four things you have to do in creating an ethical culture: ● Teach—Be certain that in training, performance reviews, mentoring and discipline processes that you're reinforcing the kind of behavior that you want. Identify what that value looks like in the company culture you're trying to establish and be sure that employees or vendors know what it looks like. ● Enforce—Have appropriate consequences and praise that are proportional to behavior. Remember, what you allow you encourage. ● Advocate—The values you hope to establish should be displayed on the walls, part of performance reviews, recruiting literature and annual reports as this is what our company stand for. ● Model—Be certain that as a manager your conduct models what you expect from your employees and vendors.

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Chapter 4: AICPA Code of Professional Conduct MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

1) Professional judgment is influenced by A) organizational values.

B) personal code of ethics.

C) cognitive biases.

D) organizational dissonance.

2)

Personal values link to A) ethical judgment and motivation.

B) ethical motivation and action.

C) ethical sensitivity and action.

D) ethical sensitivity and judgment.

3)

The KPMG Professional Judgment Framework defines judgment as

A) the process of reaching a decision or drawing a conclusion where there are a number of possible alternative solutions.

B) the process of making a judgment where there are a number of possible virtues.

C) the process of acting in accordance with the AICPA Code.

D) the process of deciding when giving voice to one's values.

4) Which of the following is not a component of the KPMG Professional Judgment Framework?

A) clarify issues and conclusions B) clarify issues and objectives C) gather and evaluate information D) articulate and document rationale

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5)

Common judgment traps include A) group think, judgment triggers, and reacting to pressures.

B) group think, judgment triggers, and a rush to solve problems.

C) reacting to pressures, a rush to solve problems, and Systems 1 thinking.

D) systems 1 thinking, cognitive dissonance, and a rush to solve problems.

6)

Which of the following is not a common judgment tendency?

A) availability tendency B) confirmation tendency C) overconfidence tendency D) decision making tendency

7)

The anchoring tendency relates to

A) starting from an initial numerical value and then adjusting insufficiently away from it in forming a final judgment.

B) starting from management's estimate and then adjusting sufficiently away from it in forming a final judgment.

C) developing a system to give voice to one's values.

D) developing a decision making framework.

8) The tendency for decision-makers to put more weight on information that is consistent with their initial beliefs or preferences is called the A) availability tendency.

B) confirmation tendency.

C) overconfidence tendency.

D) decision making tendency.

9)

Professional skepticism can best be defined as having

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A) an inquiring mind and deliberate decision making.

B) deliberate decision making and suspension of belief.

C) an inquiring mind and suspension of belief.

D) careful observation and virtue-based decision making.

10)

Professional skepticism links to professional judgment through the ethical standards of A) independent thought, objectivity, and intelligence.

B) objectivity, intelligence, and reflective thought.

C) independent thought, objectivity, and due care.

D) honesty, integrity, and due care.

11) Madison is in the process of gathering evidence to support the audit opinion on Jefferson & Adams, Incorporated. She's a new staff accountant and wants to make sure she exercises the appropriate level of professional skepticism. Madison asks for your advice as the senior on the audit. How best might you guide her as to the skepticism issues?

A) Accept management's representation unless they fail to provide adequate supporting documentation.

B) Always review the evidence you gather to assess persuasiveness.

C) Approach the audit assuming fraud does exist.

D) Keep an open mind and rely on your team in making professional judgments.

12) Jacob just joined the firm of Gordon & Towns LLC. Prior to beginning his first group audit assignment, Jacob asks to meet with his mentor, Isaac. He asks Isaac how making judgments in an audit team setting differs from running an audit oneself. What is the best advice for Isaac to give to Jacob?

A) They are not the same.

B) Groups are not prone to judgment traps and biases.

C) Groups are prone to making quick decisions in order to avoid conflict.

D) Good judgment principles apply only in group settings since other are involved.

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13) In gathering audit evidence, the accessibility of information may be a factor thereby influencing which judgment tendency?

A) confirmation B) overconfidence C) anchoring D) availability

14) In gathering audit evidence, the possibility of overestimating one’s abilities to perform tasks or to make accurate diagnoses may be a factor thereby influencing which judgment tendency?

A) confirmation B) overconfidence C) anchoring D) availability

15) In gathering audit evidence, the auditor starting from an initial numerical value and then adjusting insufficiently in forming a final judgment may be a factor influencing which judgment tendency?

A) confirmation B) overconfidence C) anchoring D) availability

16) When a CPA whistle blows against an employer under SOX or Dodd-Frank, this is an example of which threat?

A) adverse interest B) advocacy C) familiarity D) self-interest

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17) When a CPA promotes an employing organization’s interests to the point that his objectivity is compromised, this is an example of which threat?

A) adverse interest B) advocacy C) familiarity D) self-interest

18) When a CPA develops a close relationship with an employing organization that causes the CPA to become too sympathetic to the organization’s interests, this is an example of which threat?

A) adverse interest B) advocacy C) familiarity D) self-interest

19)

What question has been raised over the last 40 years of financial frauds?

A) Why was fraud allowed to occur at so many companies?

B) Where was the board of directors in all these frauds?

C) Where were the auditors?

D) Why did the internal controls fail in so many frauds?

20) Which PCAOB rule establishes the requirement for the accounting firm to be independent of its audit client throughout the audit and professional engagement period?

A) Rule 3520 B) Rule 3521 C) Rule 3522 D) Rule 3523

21) Which PCAOB rule treats registered public accounting firms as not independent of their audit clients if the firm, or any affiliate of the firm, receives payment for services rendered?

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A) Rule 3520 B) Rule 3521 C) Rule 3522 D) Rule 3523

22) The PCAOB was formed and instituted a mandatory quality inspection program. What has been the average audit deficiency rate range since the program started?

A) 5 to 9% B) 10 to 19% C) 20 to 29% D) 30 to 42%

23) Which PCAOB rule considers that the public accounting firm is not independent of its audit client if the firm provides any nonauditing service to the audit client related to marketing, planning, or an “aggressive tax position” transaction?

A) Rule 3520 B) Rule 3521 C) Rule 3522 D) Rule 3523

24)

The growth in consulting services raises questions about which professional obligation?

A) objectivity B) confidentiality C) competence D) conflicts of interest

25)

The most significant change in the Revised AICPA Code of Professional Conduct is

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A) a conceptual framework approach for evaluating ethics violations.

B) the creation of two conceptual frameworks: one for members in public practice and one for members in business.

C) eliminating Code coverage for members in business.

D) clarifying that all CPAs must follow the Independence rule regardless of professional services.

26)

Which of the following is established by the conceptual framework in the AICPA Code?

A) threats and safeguards approach to assess whether ethics rules have been violated B) rules to assess independence violations apart from those affecting other services C) new rule on when to follow the Dodd-Frank whistle-blower's act D) legal liability of auditors

27) The SEC approach to independence emphasizes independence in fact and appearance in all of the following ways except A) proscribing certain financial interests in an audit client.

B) whether a conceptual framework approach is used for evaluating ethics violations.

C) restricting certain nonauditing services to audit clients.

D) subjecting all auditor conduct to a standard of independence.

28)

One reason independence in appearance is used to evaluate threats to independence is

A) factual independence is based on unobservable matters.

B) independence in appearance links to other rules of conduct.

C) threats to independence can only be measured using a safeguards approach.

D) threats to independence always exist when perceptions indicate a conflict of interests may exist between the auditor and client.

29)

An example of a management participation threat is

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A) establishing and maintaining the budget for audit completion.

B) establishing and maintaining internal controls for the client.

C) initiating litigation against the client.

D) preparing source documents used to generate the client's financial statements.

30)

An example of a self-review threat is A) establishing and maintaining the internal controls for the client.

B) preparing source documents used to generate the client's financial statements.

C) promoting the client's securities through investment banking activities.

D) borrowing money from the client.

31) Which of the following is not a safeguard that can help to mitigate threats to independence?

A) safeguards created by the Sarbanes-Oxley Act B) safeguards created by the corporate governance system of the attest client C) quality control safeguards created by the audit firm D) safeguards performed by the audit firm that are the responsibility of management.

32)

Safeguards implemented by the attest client include each of the following except A) proper oversight by client management.

B) management participation in the client by the attest firm.

C) policies and procedures to address ethical conduct.

D) the tone at the top set by executive management.

33) The principle of ethical behavior in the AICPA Code that asks questions directly related to ethical courage is

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A) independence.

B) objectivity.

C) integrity.

D) due care.

34)

Impairments of independence can occur when A) a CPA owns a direct financial interest in a client.

B) a CPA owns a material indirect financial interest in a client.

C) immediate family members of the CPA are in violation of the independence rules.

D) All of these choices are correct.

35) Independence may be impaired when a partner leaves an audit firm and is subsequently employed by the client if A) that partner is in a position to influence the management's decisions with respect to the audit.

B) that partner is in a position to influence the accounting firm's operations.

C) that partner serves on the board of directors of the client.

D) amounts due the former partner are not material to the firm.

36) An unacceptable threat to independence occurs when a CPA performs nonaudit services for an audit client unless the CPA A) assumes all management responsibilities.

B) accepts management's responsibility for the services.

C) evaluates the adequacy of the services.

D) evaluates the results of the services.

37) Which PCAOB rule treats a registered public accounting firm as not independent if the firm provides tax services to certain members of management who serve in financial reporting oversight roles at an audit client or to immediate family members?

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A) Rule 3520 B) Rule 3521 C) Rule 3522 D) Rule 3523

38)

The SEC's position on independence can best be characterized as A) permitting certain financial interests with the client.

B) prohibiting auditors from providing tax advice to audit clients.

C) proscribing certain business relationships with the client.

D) banning the provision of all nonaudit services to audit clients.

39) Section 201 of SOX provides that all of the following services may not be performed for attest clients except A) financial information systems design.

B) appraisal or valuation services.

C) internal audit outsourcing services.

D) legal services related to the audit.

40)

In the PeopleSoft case, the auditors violated what aspect of independence?

A) The auditor borrowed money from the client.

B) The auditor was exposed to an intimidation threat by the client.

C) The auditor was involved in a business relationship with the client.

D) The auditor served in a management decision making position with the client.

41) On February 13, 2019, the SEC announced that Deloitte Touche Tohmatsu LLC (Deloitte Japan) will pay $2 million to settle charges by the SEC that the firm violated auditor independence rules because it

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A) issued audit reports for a client at a time when dozens of its employees maintained bank accounts with the client’s subsidiary.

B) provided audit services to affiliate companies while owning stock in those companies.

C) had a management decision-making position in affiliate companies that the firm audited.

D) had a business relationship with management of an affiliate company it was auditing.

42) On July 1, 2015, the SEC proposed rules directing U.S. stock exchanges to create listing standards allowing A) certain nonaudit services to an audit client.

B) audit services to a client when engaged in a business relationship with management.

C) recovery or “claw back” incentive-based compensation received by executive officers as a result of materially incorrect financial statements.

D) personally buying stock of audit clients after receiving confidential information.

43)

The insider trading case against Scott London focused on A) providing confidential information about audit clients to a friend.

B) personally buying stock of audit clients after receiving confidential information.

C) providing confidential information about audit clients to his son.

D) personally selling stock of audit clients after receiving confidential information.

44)

The insider trading case against Thomas Flanagan focused on

A) providing confidential information about audit clients to a friend.

B) personally trading in securities of audit clients after receiving confidential information.

C) providing confidential information about audit clients to his business partner.

D) accepting a position with an audit client after receiving positive confidential information.

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45) Which PCAOB rule requires audit committee preapproval to perform for an audit client any permissible tax service?

A) Rule 3524 B) Rule 3525 C) Rule 3526 D) Rule 3527

46)

A conflict of interest exists when

A) a professional service or relationship creates a situation that might impair completion of the audit.

B) a professional service or relationship creates a situation that might impair objective judgment.

C) professional skepticism fails to meet objective standards.

D) All of these choices are correct.

47)

Which of the following is not an example of a conflict of interest?

A) advising two clients at the same time who are competing to acquire the same company when the advice might be relevant to the parties' competitive positions B) advising a client to invest in a business in which, for example, the immediate family member of the CPA has a financial interest in the business C) providing tax or personal financial planning services for several members of a family whom the CPA knows to have opposing interests D) accepting commissions in a financial planning engagement for a nonaudit client

48)

A CPA can accept a gift from a client as long as

A) adequate safeguards exist to prevent any threats to compliance with the Integrity and Objectivity rule.

B) adequate internal controls exist in the client entity to ensure gifts are made without any pre-conditions.

C) the amount is below what is considered to be a material payment.

D) audit services are not provided to the client.

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49) Michael has been approached by the CEO of an audit client and offered two tickets to the FIFA tournament at the Olympic Games. The CEO knows that Michael has always wanted to attend the Olympic Games and thought this was a nice way to thank him for twenty-years of excellent professional services. From an ethical perspective in deciding whether to accept the gift Michael should consider whether A) he has the time and money to travel to the games.

B) threats created by the gifts are at an acceptable level.

C) the audit has been completed for the current year.

D) nonaudit services are also provided for the client.

50)

To prevent subordination of judgment, a CPA should evaluate threats to A) Independence and Due Care.

B) Objectivity and Integrity.

C) Integrity and Due care.

D) Independence and Scope of Services.

51) CPAs in business face threats to independence just as CPAs in public practice. Which of the following threats do not exist for CPAs in business?

A) adverse interest threat B) advocacy threat C) self-interest threat D) management participation threat

52)

An example of a self-review threat for CPAs in business is A) serving as both the CFO of a company and member of its audit committee.

B) owning stock in the company the CPA works for.

C) internal auditor accepts work she previously performed in a different position.

D) serving as both the CFO of a company and member of the board of directors.

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53) Which of the following is not a safeguard to mitigate threats to compliance with the rules for CPAs in business or reduce them to an acceptable level?

A) independent external audit B) tone at the top C) independent audit committee D) whistleblower hot line

54)

Ethical conflicts for CPAs in business can occur when

A) obstacles exist to complying with professional and legal standards.

B) relationships exist with vendors.

C) threats from higher levels of management create constraints to providing accurate and reliable financial statements.

D) All of these choices are correct.

55) Which of the following is not an example of a conflict situation for CPAs in business that may lead to subordination of judgment?

A) making, permitting, or directing another party to make materially false and misleading entries in an entity's financial statements or records.

B) failing to correct the entity's financial statements or records that are materially false and misleading when the CPA has the authority to record the entries.

C) signing, permitting, or directing another to sign a document containing materially false and misleading information.

D) preparing the financial statements and auditing the same work.

56) Which of the following is not an outright restriction on providing nonattest services for an attest client?

A) tax services B) financial information systems design and implementation C) appraisal or valuation services D) internal audit outsourcing services

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57) Under the Sarbanes-Oxley Act, the auditor's responsibility with respect to internal controls can best be stated as A) develop a system of internal controls that help to prevent and detect fraud.

B) assess whether the internal controls help to prevent and detect fraud.

C) assess management's report on internal controls.

D) prepare a report on internal controls to be provided to management.

58)

The due care principle in the AICPA code A) addresses the quality of the individual who performs professional services.

B) addresses the quality of services performed by the CPA. C) addresses whether the independence standards have been met.

D) addresses whether integrity and objectivity have been compromised.

59) Which rule of professional conduct in the AICPA Code does not apply both to internal and external accountants who are CPAs and members of the Institute?

A) independence B) integrity C) objectivity D) due care

60) The confidentiality standard in the AICPA code provides a blanket exception to the rule in each of the following situations except A) in response to a validly issued court summons.

B) to provide information to the PCAOB in its inspection process.

C) to defend oneself in an ethics investigation.

D) in response to a successor auditor's request.

61)

A common requirement/effect of the commissions and contingent fees rule is

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A) a CPA who accepts such a payment always violates independence.

B) the CPA must disclose the acceptance of such a payment to the firm.

C) a CPA is prohibited from accepting such a form of payment when engaged in attest services for a client.

D) the CPA must not turn over any working papers that might constitute client books and records.

62)

Ethics rules in the AICPA Code apply to A) individual CPAs who are licensed by state boards of accountancy only.

B) individual CPAs who are licensed by state boards of accountancy and accounting

firms.

C) licensed accounting firms and certain members of alternative practice structures.

D) individual CPAs who are licensed by state boards of accountancy, licensed accounting firms, and certain members of alternative practice structures.

63)

A CPA can accept a contingent fee in providing tax services for an attest client if A) the CPA discloses this fact to the tax client.

B) the CPA receives the permission of the client to accept such a form of payment.

C) the CPA's tax services will be reviewed by a taxing authority.

D) All of these choices are correct.

64)

Objectivity may be impaired when a CPA prepares a tax return for a client because A) the CPA violates the independence rule.

B) the CPA violates the integrity rule.

C) the CPA serves in a tax advocacy position for the client.

D) the CPA must prepare the tax return solely based on the information provided by the

client.

65)

CPAs can advertise and solicit clients as long as such practices are

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A) conducted in a professional manner.

B) informative about the CPA's services.

C) not conducted in a misleading or deceptive manner.

D) paid for by outside parties.

66)

Tax avoidance transactions are often called A) earnings management.

B) tax shelters.

C) employee fraud.

D) attest services.

67) Statement on Standards for Tax Services No. 1 establishes as a basic principle of providing tax services that the CPA A) must have a good faith belief that the tax return position will be accepted by the IRS. B) must have a good faith belief that the tax return position has a realistic possibility of success if challenged by the IRS. C) can never recommend a tax position to the client when it is more likely than not to be challenged by the IRS. D) can never recommend a tax position to the client without disclosing it to the SEC.

68) The requirement that there should be reasonable support for a tax return position before a CPA recommends it to a client most directly aligns with which tax standard?

A) The tax return should not be based on a frivolous position.

B) There is a realistic possibility of success if the tax position is challenged.

C) It is more likely than not that the tax position will be upheld if challenged.

D) Contingent fees cannot be accepted when providing tax services for an audit client.

69) The CPA firm that became involved in tax shelter controversies with the IRS and settled the case for $456 million to prevent the firm’s criminal prosecution is

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A) Ernst & Young.

B) Deloitte & Touche.

C) PricewaterhouseCoopers.

D) KPMG.

70)

Which of the following is not something the CPA should do in tax planning?

A) uncritically accept the client's explanations for assumptions and representations.

B) establish the relevant background facts.

C) consider the reasonableness of the assumptions and representations.

D) consider the business purpose and economic substance of the transaction, if relevant to the tax consequences of the transaction.

71)

The PCAOB rules prohibit auditors from

A) providing certain aggressive tax shelters to their public company audit clients.

B) providing tax services to members of the audit client's management who serve in financial reporting oversight roles.

C) providing tax preparation and planning services for public company executives.

D) All of these choices are correct.

72)

To whom does the CPA owe ultimate allegiance in carrying out professional obligations?

A) stockholders.

B) public interest.

C) client.

D) stakeholders

73) A threat to replace a CPA or CPA firm because of a disagreement with the client over the application of an accounting principle is

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A) management participation threat.

B) advocacy threat.

C) self-Review threat.

D) undue influence threat.

74)

Why don't auditors prepare financial statements, as well as audit them?

A) It would take away a job from the controller of the company.

B) It would not eliminate errors in the financial statements.

C) It would be a conflict of interest and violate ethical standards.

D) It would not streamline the process and be effective.

75) Which statement is correct with respect to a CPA's ethical obligation to return client books and records and CPA workpapers?

A) Client-provided records in the custody or control of the CPA should be returned to the client at the client's request.

B) CPA workpapers should be given to the client at the end of each audit.

C) CPA work product never has to be turned over to the client.

D) Client-provided records should be destroyed after the audit.

76) George has been asked by his audit client to provide income tax services including tax planning. Prior to providing such services, George should be certain that A) he first completes the audit.

B) he assesses threats to independence.

C) the CEO pre-approves the performance of such services.

D) the board of directors is informed about such services.

77) Diane is a CFO at We Do What We Want, Incorporated. She was just instructed by her boss, the CEO, to accelerate the recording of revenue into an earlier year to meet financial analysts' earnings projections. In order to meet the ethical standards of the accounting profession, Diane must be certain that she

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A) blows the whistle on the financial wrongdoing.

B) reports the matter to the SEC. C) informs the external auditors.

D) works through the chain of command within the company to avoid subordinating judgment.

78) Which of the following statements best reflect the ethical obligation of CPAs with respect to working with outside advertising agencies to market professional services for the CPA? A) make sure that advertising is done professionally B) prohibit advertising on social media C) make sure the agency does not do anything that would put you in violation of the ethics rules D) prohibit statements about the scope of professional services

79)

One of the differences between the ethical obligations of CPAs and lawyers is

A) lawyers are obligated first and foremost to the public interest while CPAs are obligated to their clients' interests.

B) lawyers are obligated first and foremost to the client's interest, while CPAs are obligated to the public interest.

C) lawyers and CPAs both must be independent of their clients.

D) lawyers and CPAs must exercise objective judgment.

80)

The KBC Solutions case deals with

A) whether the controller should give in to the pressure and go along with false financial statements.

B) whether the senior in charge of an audit can provide adequate explanations for the accounting for transactions being questioned by the review partner.

C) whether the senior in charge of an audit pressures staff accountants to not increase the workload at year-end because of audit budget considerations.

D) whether an audit firm should go along with the client's demands for accelerating the recording of revenue.

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81)

The ethical issue in the Beauda Medical case is

A) whether an audit firm should inform one audit client about malfunctioning equipment at another client that the former plans to buy.

B) whether an audit firm should inform one audit client about fraudulent financial statements of another client.

C) whether certain expenditures should be capitalized rather than expensed.

D) whether revenue should be accelerated into an earlier period.

82)

The Family Games case deals with the following accounting issue

A) whether an audit firm should inform one audit client about fraudulent financial statements of another client.

B) whether certain expenditures should be capitalized rather than expensed.

C) whether revenue should be accelerated into an earlier period.

D) whether depreciation should be reduced by 20 percent to increase earnings.

83)

Commercialism versus Professionalism raises issues about A) the future of the accounting profession.

B) pressures to compromise ethical values that exist in alternative practice structures.

C) low-ball bidding for audit services.

D) opinion shopping.

84)

In Han, Kang & Lee, LLC, the main accounting issue being discussed with the client is

A) whether to write-down inventory by 20 percent.

B) whether to increase the value of inventory by 20 percent.

C) whether to record an expenditure of $2 million as a capital expense and not operating expense.

D) whether to inform the audit committee of fraud.

85)

The Tax Shelters case deals with

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A) ignoring the recording of lottery gains in a client's tax return.

B) changing culture in the tax department of a CPA firm.

C) pressure from one's superior to manipulate financial statements.

D) whether to sell tax shelter products to members of the audit firm.

86)

Karen Ward faced an ethical dilemma at Ernst & Young related to A) merger and acquisition services provided for an audit client.

B) sexual discrimination and harassment.

C) insufficient records and documents.

D) personal relationships between company management and external auditors.

87)

EY partner Pamela Hartford violated Independence Rules when A) she prepared financial statements and provided attest services for her audit client.

B) she identified the firm’s protective covenants are reasonable in scope.

C) she refused to maintain adequate records and documents.

D) she maintained a personal relationship with a member of company management.

88)

The Marcum LLP case focuses on

A) whether tax documents were properly filed with the IRS. B) whether a firm’s protective covenants are reasonable in scope.

C) whether the firm appropriately addressed potential independence issues.

D) whether personal relationships between company management and external auditors is allowed.

89) How did PwC violate SEC rule 2-02(b) of Regulation S-X and PCAOB Rule 3525 in 2014?

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A) PwC provided Merger and acquisition services for an audit client.

B) PwC mischaracterized nonaudit services as part of the audit engagement.

C) PwC managers sexually harassed new hires.

D) PwC audit partners had personal relationships with client management.

ESSAY. Write your answer in the space provided or on a separate sheet of paper.

90) Why is professional judgment important in accounting?

91)

Describe the characteristics of the KPMG Professional Judgment Framework.

92) Discuss how professional skepticism relates to conducting a proper audit and meeting ethical obligations under the AICPA Code.

93)

Describe the basic features of the Revised AICPA Code of Professional Conduct.

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94) Discuss the conceptual framework for independence in the Revised AICPA Code and how it deals with risks to independence.

95) Explain when and how to evaluate whether certain nonattest services can be provided to attest clients.

96) Why do CPAs have to be aware of ethical conflicts in performing professional services and which rules of conduct are most directly affected by the evaluation? How do CPAs assess risks due to ethical conflicts and possible impairments of the rules?

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97) Explain how CPAs should evaluate risks to integrity and objectivity when considering providing gifts to audit clients and/or client management or accepting risks from them.

Gifts made or received, in particular, may cloud audit judgment and impair independence. They can compromise objectivity and integrity because of the size and/or importance of the gift and the purpose of giving it or receiving it from the client. To avoid a conflict of interest that may impair integrity, objectivity, and independence, the following guidelines should be followed.

If the audit is completed, the first question is whether the acceptance of the gift might make it appear to a reasonable observer that the gift is intended to influence the audit opinion. If so, that would create an undue influence threat and compromise integrity and objectivity. Also, it could be perceived as an advance payoff for future audit opinions. The influence does not have to be immediate. Beyond that, an important issue to consider is: Would acceptance violate any laws, regulations, or firm policies. If so, acceptance would create a threat that cannot be reduced or eliminated through any safeguards. If not, consider the following: ● What is the nature, value, and intent of the gift? ● Is it more than clearly inconsequential? ● Is it reasonable in the circumstances? ● Is it standard practice to accept or reject such gifts? ● Does the client expect a "quid pro quo?"

98) What is the purpose of the confidentiality rules in the AICPA Code? Describe the specific provisions and when confidentiality requirements might be waived.

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99) A young man by the name of Mr. Hicks works at an accounting firm which has a written ethics code of conduct. The code specifically outlines the duties and obligations that every employee must follow without question. One of the rules states that every accountant should not lie under any circumstances.

Last week Mr. Hicks sent out a finalized tax return to the Wrong client. The Wrong client called Hicks and informed him that he was sending the tax return back to him overnight. Meanwhile the Right client called Hicks and wanted to know where the tax return was. Hicks told the Right client that he sent it to the wrong address and he will send out the return the next day. The Right client was irritated and called the partner of the firm.

The partner scolded Hicks and wanted to know why he told the client he sent the return to the wrong address. The partner said he should have told the client that the return was in the 2nd partner review or some other excuse to cover up the mistake. Hicks explained that the ethics code of conduct specifically states that he should not lie under any circumstances and he was just following his ethical duty. The partner grinned and told Hicks that the next time this happens he should consult with the partner first.

Using the ethical decision making model and ethical theories, justify the positions of the partner, Hicks or an alternative solution.

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Answer Key Test name: Chap 04_6e_ Mintz 1) C 2) D 3) A 4) A 5) B 6) D 7) A 8) B 9) C 10) C 11) B 12) C 13) D 14) B 15) C 16) A 17) B 18) C 19) C 20) A 21) B 22) D 23) C 24) D 25) B 26) A Version 1

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27) B 28) A 29) B 30) B 31) D 32) B 33) C 34) D 35) B 36) B 37) D 38) C 39) D 40) C 41) A 42) C 43) A 44) B 45) A 46) B 47) D 48) A 49) B 50) B 51) D 52) C 53) A 54) D 55) D 56) A Version 1

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57) C 58) B 59) A 60) D 61) C 62) D 63) C 64) C 65) C 66) B 67) B 68) B 69) D 70) A 71) D 72) B 73) D 74) C 75) A 76) B 77) D 78) C 79) B 80) B 81) A 82) C 83) B 84) A 85) B 86) B Version 1

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87) D 88) C 89) B 90)Professional judgment is the basis for deciding issues related to the acceptability of audit evidence and presentation of the financial statements. It is an essential element of due care and must be accomplished through an objective mindset and the exercise of professional skepticism.

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 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.

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 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.

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91)KPMG developed a framework of the elements of professional judgment in its monograph, Elevating Professional Judgment in Auditing and Accounting: 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. 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.

The framework is prescriptive. In the real world we may deviate from the process because of pressures, time constraints, and limited capacity.

These constraints, influences, and biases threaten good judgment.

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.

As decision makers navigate through the professional judgment framework, judgment traps and tendencies can lead to bias. One common judgment trap is the tendency to want to immediately solve a problem by making a quick judgment. This could lead the auditor to Version 1

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shortcut the process by accepting copies of original documents rather than spending the time to convince the client of why originals are needed.

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92)Professional skepticism includes being alert to: ● Audit evidence that contradicts other audit evidence obtained. ● Information that brings into question the reliability of documents and responses to inquiries to be used as audit evidence. ● Conditions that may indicate possible fraud. ● Circumstances that suggest the need for audit procedures in addition to those required by the generally accepted auditing standards.

Professional skepticism is used as a means of enhancing the auditor's ability to identify risks of material misstatement and to respond to the risks identified. Professional skepticism is closely related to fundamental ethical considerations of auditor objectivity and independence. It also links to the application of professional judgment by the auditor. An audit performed without an attitude of professional skepticism is not likely to be a high-quality audit. At its core the application of professional skepticism should help to ensure that the auditor does not neglect unusual circumstances, oversimplify the results from audit procedures, or adopt inappropriate assumptions when determining the audit response required to address identified risks, all of which should improve audit quality.

The auditor is likely to apply professional skepticism at various stages from client acceptance and at various points during the audit process, and some typical examples are given below: ● When assessing engagement acceptance — at this stage the auditor should consider whether the management of the intended audit client acts with integrity and whether there are any matters that may impact on the auditor being able to act with professional skepticism if they accept the engagement, such as ethical threats to objectivity. ● When performing risk assessment procedures — an auditor should be skeptical when performing risk assessment procedures at the planning stage of the audit. For example, when discussing the results of analytical Version 1

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procedures with management, the auditor should not accept management's explanations at face value, and should obtain corroboratory evidence for the explanations offered. ● When obtaining audit evidence — the auditor should be ready to challenge management, especially on complex and subjective matters and matters which require a degree of judgement to be exercised by management. The reliability and sufficiency of evidence should be considered, especially where there are risks of fraud. There may also be specific issues arising during an audit which impact professional skepticism — for example, if management refuses the auditor's request to obtain evidence from a third party. The auditor will have to consider how much trust can be placed on evidence obtained from management — for example, evidence in the form of enquiry with management or written representations obtained from management. ● When evaluating evidence — the auditor should critically assess audit evidence and be alert for contradictory evidence that may undermine the sufficiency and appropriateness of evidence obtained.

The auditor should also apply professional skepticism when forming the auditor's opinion, by considering the overall sufficiency of evidence to support the audit opinion, and by evaluating whether the financial statements overall are a fair presentation of underlying transactions and events.

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93)● Emphasizes the public interest as the cornerstone ethical obligation. ● Separate rules for CPAs in public practice and members in business. ● Emphasizes a threats and safeguards conceptual framework approach to evaluating possible violation of the rules of conduct. ● Uses a risk-based approach to assess whether safeguards adequately reduce or eliminate risk. ● Provides guidance on how to deal with ethical conflicts that might impair objectivity and integrity. ● Organizes the Code by subject matter rather than rules, interpretations, and rulings. ● Specific requirements to avoid subordination of judgment for CPAs when differences exist with supervisors and auditors within the audit firm.

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94)Independence in fact requires avoiding relationships that might impair audit independence including owning a direct financial interest in a client or a material indirect financial interest. It also requires avoiding certain relationships with management and/or the client entity described below that can create risks to independence including those described below.

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 Self-Interest 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.

Management Participation Threat Establishing and maintaining internal controls.

Auditors must evaluate whether risks exist that might create threats to independence and whether they can be mitigated through safeguards.

The risk-based approach involves the following steps: 1. Identifying and evaluating threats to independence.

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2. Determining whether safeguards already eliminate or sufficiently

mitigate identified threats and whether threats that have not yet been mitigated can be eliminated or sufficiently mitigated by safeguards.

3.If no safeguards are available to eliminate an unacceptable threat or reduce it to an acceptable level, independence would be considered impaired.

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 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.

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95)Nonattest services can cloud objective judgment and make it more difficult to exercise professional skepticism. A major issue related to independence includes whether certain nonattest services should be provided to audit clients. Section 201 of SOX provides that the following nonattest services may not be performed for attest clients in addition to bookkeeping or other services related to the accounting records or financial statements of the audit client: 1.Financial information systems design and implementation 2.Appraisal or valuation services, fairness opinions, or contribution-inkind reports 3. Actuarial services 4. Internal audit outsourcing services 5.Management functions or human resources 6.Broker or dealer, investment adviser, or investment banking services 7.Legal services and expert services unrelated to the audit 8.Any other service that the board of directors determines, by regulation, is impermissible SOX allows an accounting firm to "engage in any nonaudit service, including tax services," that is not listed above, only if the activity is preapproved by the audit committee of the issuer company. The preapproval requirement is waived if the aggregate amount of all such nonaudit services provided to the issuer constitutes less than 5 percent of the total amount of revenues paid by the issuer to its auditor.

As previously mentioned, concern exists in Congress and the SEC about a possible impairment of audit independence when the firm also provides nonaudit services for the client. An example of a prohibited activity under AICPA and SEC rules is that a CPA should not perform management functions or make management decisions for an attest client. The relationship creates a management participation threat that places the CPA in the compromising position of making decisions for Version 1

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the client and then auditing those decisions. On the other hand, the CPA may provide advice, research materials, and recommendations to assist the client's management in performing its functions and making decisions.

The Code establishes requirements that must be met during the period covered by the financial statements and the period of the attest engagement by the CPA in order to conduct nonattest services for the client without impairing audit independence. Under Code Section 1.295, individual nonatttest services may be permitted because adequate safeguards are provided by the Interpretation. However, when performing multiple services there may be unacceptable threats (i.e., management participation, self-review) to independence.

General requirements exist for the attest client when a CPA performs nonattest services, including: ● Assume all management responsibilities. ● Oversee the service, by designating an individual, preferably within senior management, who possesses suitable skill, knowledge, and/or experience. ● Evaluate the adequacy and results of the services performed. ● Accept responsibility for the results of the service.

Other requirements exist, including to clearly establish the objectives of the engagement, services to be performed, and client's acceptance of its responsibilities, member's responsibilities, and any limitations of the engagement.

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96)Under the Revised Code, when evaluating whether a CPA in public practice is in compliance with the rules, a CPA should assess whether an ethical conflict exists. Ethical conflicts create challenges to ethical decision making because they present barriers to meeting the requirements of the rules of conduct. An ethical conflict may exist, for example, if a CPA in public practice suspects a fraud may have occurred, but reporting the suspected fraud would violate the confidentiality obligation.

Exhibit 3.15 establishes the rules to avoid a subordination of judgment in violation of integrity and objectivity and gives guidance in instances where whistle-blowing is being considered. These rules are now covered in Section 1.130.020 of the Revised Code and will be discussed later on.

Exhibit 4.3 identifies the major considerations for CPAs in assessing the risk that ethical conflicts may lead to a violation of the rules of conduct.

Briefly, the CPA should consider whether any departures exist to the rules, laws, or regulations and how they will be justified in order to ensure that conflicts are resolved in a way that permits compliance with these requirements. Resolution of the conflict may call for consulting with those in the entity or others, including legal counsel. Any unresolved conflicts can lead to a violation of the rules of conduct which, in turn, should focus the CPA's attention on any continuing relationship with the engagement team, specific assignment, client, firm, or employer.

The Revised Code addresses the Integrity and Objectivity Rule (1.100.001) by linking it to challenges from conflict of interest situations and subordination of judgment. In the absence of an interpretation that addresses a particular relationship or circumstance, the CPA should apply the conceptual framework approach to evaluate threats and safeguards. Guidance under the ethical conflicts framework also should be considered (Exhibit 4.4) when addressing such obstacles to ensure Version 1

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proper handling of internal or external pressures that create barriers to following the professional or legal standards, or both.

Conflicts of interest (1.110.010) for members in public practice occur when a professional service, relationship, or specific matter creates a situation that might impair objective judgment. Determinations are made through the application of professional judgment in order to evaluate whether a reasonable and informed third party who is aware of the relevant information would conclude that a conflict of interest exists.

A conflict of interest creates adverse and self-interest threats to integrity and objectivity. For example, threats may occur when the CPA/CPA firm provides a professional service related to a particular matter involving two or more clients whose interests are in conflict, or the firm's interest and that of the client are in conflict.

Illustrations of conflicts are given in the rules. A few examples follow: ● Providing corporate finance services to a client seeking to acquire an audit client of the firm, when the firm has obtained confidential information during the course of the audit that may be relevant to the transaction. ● Advising two clients at the same time who are competing to acquire the same company when the advice might be relevant to the parties' competitive positions. ● Providing services to both a vendor and a purchaser who are clients of the firm in relation to the same transaction. ● Advising a client to invest in a business in which, for example, the immediate family member of the CPA has a financial interest in the business. ● Providing forensic investigation services to a client for the purpose of evaluating or supporting contemplated litigation against another client of the firm. ● Providing tax or personal financial planning services for several Version 1

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members of a family whom the CPA knows to have opposing interests. ● Referring a personal financial planning or tax client to an insurance broker or other service provider, which refers clients to the CPA under an exclusive arrangement.

To identify possible conflicts of interest, the CPA should examine situations that may create threats to compliance with integrity and objectivity prior to acceptance of the engagement and throughout the term of the relationship. This includes matters identified by external parties including current or potential clients. The earlier a potential conflict is identified, the greater the likelihood of applying safeguards to eliminate or reduce significant threats to an acceptable level. If the threat has not been eliminated or reduced to an acceptable level, then appropriate safeguards should be applied to ensure acting with objectivity and integrity.

Examples of safeguards include: (1) implementing mechanisms to prevent unauthorized disclosure of confidential information of one or more clients when performing professional services for two or more clients whose interests conflict; (2) regularly reviewing the application of safeguards by a senior individual not involved in the engagements; (3) having a member of the firm not involved in providing the services or otherwise affected by the conflict, review the work performed to assess whether key judgments and conclusions are appropriate; and (4) consulting with third parties, such as a professional body, legal counsel, or another professional accountant.

In cases where identified threats are so significant that no safeguards will eliminate them or reduce them to an acceptable level, or adequate safeguards cannot be implemented, the CPA should either decline to perform the service that would result in the conflict of interest, or terminate the relevant relationship or dispose of the relevant interests to eliminate the threat or reduce it to an acceptable level.

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When a conflict of interest exists, the CPA should disclose the nature of the conflict to clients and other appropriate parties affected by the client and obtain their consent to perform professional services even if threats are at an acceptable level. If consent is not received, then the CPA should either cease performing the services or take action to eliminate or reduce the threat to an acceptable level.

97)From an ethical perspective, the best way to approach the issue is first, apply the smell test. Second, evaluate whether acceptance is consistent with your values and those of the firm. Third, ask whether you would be comfortable explaining why you agreed to accept the gifts if you were questioned by a superior or a newspaper reporter?

It is never wise to potentially compromise your reputation and trust others place in you, so the safe way to deal with such gifts is to decline them. Thus, you will not have to explain them away at a later date.

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98)The confidentiality of information gained through one's employments as a CPA or in connection with an audit of a client's financial statements must be protected because employers and clients trust their CPAs/auditors to protect sensitive financial and other information. Trust is the basis for the relationship between those parties. Integrity also requires protecting confidential information.

A confidentiality requirement exists for employees of firms that precludes disclosing confidential employer information obtained as a result of an employment relationship, such as discussions with the employer's vendors, customers, or lenders. An example where confidential information is generally protected is customer lists, target clients, costs, and marketing strategies that might afford competitive advantages. Perhaps the most dangerous situation is when an employee leaves the company, by choice or force, and decides to use confidential information for personal gain.

Situations exist where a CPA is permitted or may be required to disclose confidential employer information under the law, such as occurs with whistle-blowing disclosures when the conditions for doing so under Dodd-Frank have been met, as discussed in Chapter 3. Disclosure also may be required to comply with a validly issued and enforceable subpoena or summons.

A professional responsibility exists to disclose confidential information under the following conditions unless prohibited by law. ● Initiate a compliant, or respond to any inquiry made by the Professional Ethics Division or trial board of the AICPA or state CPA society, or state board of accountancy; ● Protect the CPA's professional interests in legal proceedings; ● Comply with professional standards and other ethics requirements; or ● Report potential concerns regarding questionable accounting, auditing, or other matters to the employer's confidential complaint hotline or those Version 1

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charged with governance Disclosure is also permitted on behalf the employer to: ● Obtain financing with lenders; ● Communicate with vendors, clients, customers; or ● Communicate with the employer's external accountant, attorneys, regulators, and other business professionals.

Auditors in particular need to take care that confidential information is not disclosed as has happened in insider trading cases. The disclosure impairs audit independence and could lead to prosecution of the CPA/auditor, as was the case for Scott London the KPMG auditor that disclosed confidential information about two audit clients of the firm: Herbalife and Sketchers. London's disclosure led to the firm withdrawing its audit opinion on each client's financial statements.

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99)Hicks has attempted to be honest with the Right client but in an awkward way. It sounds like the return was sent to an incorrect address, not another client. Hicks should have spoken to the partner to get some advice before responding to the Right client. He has not exercised due care in his actions. Perhaps Hicks was trying to follow deontology and "rights" of the Right client. However, the way in which he went about it was short-sighted at least from the firm's point of view. In this case the ends do not justify the means. Mistakes of this kind should be dealt at the partner level.

Utilitarianism can be used to support the partner's position in that the benefits of deceiving the Right client for a short while, including holding on to the client and saving the firm's reputation, far outweigh the costs of deceiving the client. One might argue this is a situation of "no harm, no foul." However, this Act Utilitarian approach fails to recognize the utilitarian rule that clients should never be deceived.

This is a case where professional judgment was faulty. It almost seems as though Hicks acted hastily, using a Systems 1 approach, rather than in a deliberative fashion under Systems 2. He should have considered alternative ways to handle the matter rather than have a knee-jerk reaction.

Judgment occurs in a setting of uncertainty, risk, and often conflicts of interest. 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. While the framework applies more to direct conflicts with clients or on client matters, it does reflect a thoughtful process, deliberation and reflection that underlies Version 1

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professional judgment. Hicks failed in that regard.

While some students may argue a lie is a lie and Hicks did the right thing, consider whether this isn't one of those circumstances where other values supersede strict honesty, such as loyalty. While loyalty is typically secondary to other values such as honesty, the loyalty obligation in accounting is more to the public interest above all else, not to the client's interest ahead of one's employer and for "the greater good." Is the public interest served by telling the Wrong client his return was sent to the wrong address?

The case illustrates why Rights Theory can be so difficult to implement in practice. Students should enjoy the discussion.

This case can also be turned into a GVV case by having Hicks develop a game plan to convince the partner why what he did was the proper decision.

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Chapter 5: Fraud in Financial Statements and Auditor Responsibilities MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

1) Which of the following is not something external auditors are expected to do in looking for fraud?

A) assessing the control environment of the organization B) evaluating internal controls C) considering audit risk and materiality D) evaluating management's commitment to serve the public interest

2) If the financial statements are not materially misstated for a nonpublic company, the auditor should give a(an) A) unmodified opinion.

B) modified opinion.

C) adverse opinion.

D) qualified opinion.

3)

An example of fraudulent financial statements is

A) misrepresentation of events, transactions, and other significant events in the financial statements.

B) failure to provide adequate documentation to support financial statement assertions.

C) aggressive accounting for transactions, events, or other significant matters.

D) misappropriation of assets.

4)

Misstatements in the financial statements can result from A) errors.

B) fraud.

C) illegal acts improperly recorded.

D) All of these choices are correct.

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5)

Misstatements in the financial statements are most likely to occur when there is a/an A) omission of the auditor's report.

B) omission of notes to the financial statements.

C) failure to disclose major estimates made in the financial statements.

D) failure to disclose major judgments made in the financial statements.

6)

The auditor's responsibility with regard to illegal acts is greatest when A) the illegal acts have an indirect and material effect on financial statement amounts.

B) the illegal acts have a direct and material effect on financial statement amounts.

C) the illegal acts have a direct and immaterial effect on financial statement amounts.

D) illegal acts exist regardless of the effects on the financial statements.

7)

The first step for an auditor who concludes an illegal act exists is to A) bring the matter to the attention of the audit committee.

B) bring the matter to the attention of the SEC. C) assess the impact of the illegal act on the financial statements.

D) assess the impact of the illegal act on the auditor's opinion.

8) An auditor concludes that a client has committed an illegal act that has not been properly accounted for or disclosed. The auditor is most likely to withdraw from the engagement when the A) auditor is precluded from obtaining sufficient competent evidence about the illegal act.

B) illegal act has an effect on the financial statements that is both material and direct.

C) auditor cannot reasonably estimate the effect of the illegal act on the financial statements.

D) client refuses to take the remedial steps deemed necessary by the auditors.

9) The Private Securities Litigation Reform Act imposes additional requirements on public companies reporting to the SEC and their auditors when

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A) the illegal act has a material effect on the financial statements.

B) senior management and the board have not acted properly to correct for the act.

C) the failure to correct for the action is reasonably expected to warrant a departure from the standard audit report.

D) All of these choices are additional requirements.

10)

Auditors are responsible to detect and correct errors when they are A) material.

B) material or immaterial.

C) due to an illegal act.

D) management fails to correct for the error.

11) Confidential client information can be disclosed outside the entity without violating the AICPA Code of Professional Conduct in each of the following situations except when A) it is reported to the SEC under Section 10A of the Securities Exchange Act. B) it is to comply with the Private Securities Litigation Reform Act. C) it protects the auditor's accounting for fraud and illegal acts.

D) it is allowed for under the Dodd-Frank Financial Reform Act.

12)

The purpose of the fraud triangle is to identify

A) the causes of when the audit opinion should be qualified.

B) the causes of and reasons for fraud when there may be intentional misstatements or omissions of amounts or disclosures in the financial statements.

C) the causes of when there is a lack of independence in performing an audit.

D) the causes of illegal acts.

13)

Which of the following is not part of the fraud triangle?

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A) incentives B) opportunity C) materiality D) rationalization

14)

The difference between errors in the financial statements as compared to fraud is A) an error is always an intentional act designed to deceive another party.

B) fraud is always an intentional act designed to deceive another party.

C) an error always leads to a qualification of the auditors' opinion.

D) fraudulent financial reporting is always material in amount.

15)

Which of the following is not a pressure that might lead to fraud?

A) desire to maximize the value of stock options B) budget pressures C) meet financial analysts' earnings expectations D) ability to carry out the fraud

16)

All of the following are in a position to commit fraud except A) employees who have access to assets.

B) top management who can override internal controls.

C) external auditors who audit the financial statements.

D) internal auditors who test internal controls.

17)

All of the following tend to be rationalizations for fraud except A) we need to protect the shareholders and keep the stock price high.

B) all companies use aggressive accounting techniques.

C) the employee will be fired unless s/he goes along with the fraud.

D) we are correcting a temporary problem that will not exist in the future.

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18)

The best explanation why the fraud at Tyco was not discovered and acted on is A) failure of the corporate governance system.

B) external auditors told management to let the fraud go.

C) tyco management hid the fraud from the auditors.

D) the fraud was not material.

19)

Which of the following elements was not part of the fraud at Tyco?

A) benefits given to certain members of the board of directors to secure their silence about the fraud.

B) corporate assets used by members of top management for personal purposes.

C) setting up special-purpose-entities to keep debt off Tyco's books.

D) related party transactions that were not adequately disclosed.

20) In an “Analysis of Alleged Auditor Deficiencies in SEC Fraud Investigations: 1998– 2010” why were auditors unable to detect fraud?

A) a failure to exercise due professional care B) related party transactions that were not adequately disclosed C) the audit committee always sanctioned the fraud D) a minority of audit reports issued during the fraud period contained unqualified audit opinions

21) Which of the following is not one of the evaluations of the control environment of an organization?

A) whether management's philosophy and operating style promote effective internal control over financial reporting B) whether sound integrity and ethical values, particularly of top management, are developed and understood C) whether the Board or audit committee understands and exercises oversight responsibility over financial reporting and internal control D) whether the company has an anonymous hotline

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22)

What is enterprise risk management (ERM)?

A) a process of evaluating internal controls to ensure operations are carried out efficiently and effectively B) a process designed to identify material events that may affect the financial statements and to manage risk within the entity's risk appetite C) a process, effected by an entity's board of directors, management, and other personnel designed to identify potential events that may affect the entity and to manage risk within its risk appetite D) a process by which compliance with laws and regulations can be assessed

23)

Which of the following is an element of ERM? A) reducing operational surprises and losses B) aligning risk appetite and whether fraud has occurred C) control environment D) audit risk assessment

24) The auditors' responsibility to communicate findings with respect to fraud can best be summarized as A) communicate to the audit committee the existence of fraud but not the amount involved.

B) communicate to the appropriate level of management both material and immaterial amounts of fraud that are detected.

C) communicate to the SEC the existence of fraud but not the amount involved.

D) communicate to the SEC both material and immaterial amounts of fraud that are detected.

25) Which of the following is not one of the communications that should be made by external auditors to the audit committee?

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A) accounting estimates B) threats to auditor independence and related safeguards to mitigate those threats C) significant deficiencies in audit procedures D) the nature and scope of significant assumptions

26)

Section 302 of the Sarbanes-Oxley Act requires A) management's report on internal controls.

B) auditor's independent report.

C) auditor's assessment of management's report on internal controls.

D) management's certification of the financial statements.

27) In its investigation of ZZZZ Best, the House Subcommittee on Oversight and Investigations looked into A) why the board of directors failed to uncover the fraud at ZZZZ Best.

B) how the company was able to create 80% or more fictitious revenue.

C) how the company was able to create cookie jar reserves.

D) All of these choices are correct.

28)

In the business world, the term disgorgement means A) to give up one's meal after eating.

B) to return profits earned illegally.

C) to return ill-gotten gains.

D) to give up one's board position after a fraud incident.

29) Which of the following is an element of the introductory paragraph of an auditor's report under AICPA standards?

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A) identifies the type of opinion the auditor is giving.

B) identifies the entity, financial statements being audited and time period.

C) identifies audit testing and procedures used.

D) identifies the generally accepted auditing standards followed in conducting the audit.

30) Which of the following is not an element of the auditor's responsibility of the AICPA's auditor's report for nonpublic companies?

A) states the auditor's responsibility to express an opinion on the financial statements.

B) states the audit provides reasonable assurance that the statements are free of material misstatement.

C) states audit provides reasonable basis for the opinion.

D) states the audit evaluates the overall financial statement presentation.

31)

Typically, when a going concern issue exists the auditor should A) issue an unmodified opinion with an emphasis-of-matter paragraph.

B) issue a modified opinion and explain the reasons for the going concern issue.

C) issue a disclaimer of opinion.

D) withdraw from the engagement.

32)

In which of the following circumstances would a qualified opinion be appropriate?

A) The statements are not in conformity with generally accepted accounting principles regarding stock options plans and these misstatements do not have pervasive effect on the financial statements.

B) The statements are not in conformity with generally accepted accounting principles regarding stock options plans and these misstatements have pervasive effect on the financial statements.

C) The auditor has been unable to obtain sufficient competent evidential matter.

D) The principal auditors decide to withdraw from the engagement due to distrust of management.

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33) Which of the following is the most likely reason for an auditor to issue a modified opinion with a qualification?

A) inability to gather any sufficient relevant information to form the basis for the opinion B) misstatements that are material and pervasive C) going concern issue D) misstatements that are material but not pervasive

34) Which of the following is the most likely reason for an auditor to issue an adverse opinion?

A) inability to gather any sufficient relevant information to form the basis for the opinion B) misstatements that are material and pervasive C) going concern issue D) misstatements that are material but not pervasive

35) Under which of the following set of circumstances might the auditors disclaim an opinion?

A) The financial statements contain a departure from generally accepted accounting principles, the effect of which is material.

B) The auditor is unable to obtain sufficient appropriate audit evidence on which to base the opinion.

C) There has been a material change between periods in the method of the application of accounting principles.

D) Differences with management that lead to trust issues on the part of the auditor.

36)

When would it be appropriate for an auditor to withdraw from an engagement?

A) in order to avoid issuing an adverse opinion B) when that auditor cannot observe the taking of inventory or is unable to confirm receivables C) when the auditor concludes that management cannot be trusted D) when the auditor has overbooked too much work

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37)

One difference between the AICPA auditor's report and that of the PCAOB is A) the PCAOB report is not signed by the auditor.

B) the AICPA report is not signed by the auditor.

C) the PCAOB report includes a separate section on Critical Audit Matters.

D) both reports are the same.

38)

The title of the PCAOB auditor's report is A) Independent Auditor's Report.

B) Report of Independent Registered Public Accounting Firm.

C) Auditor's Report on Management's Financial Statements.

D) Auditor's Report on Internal Controls.

39)

Some critics claim the usefulness of the audit report is limited because

A) auditors do not examine management's estimates and judgments.

B) language in the audit report relies on subjective evaluations such as what is meant by "reasonable".

C) transactions examined are based on sampling and other techniques to limit choices of which transactions to audit.

D) auditors examine all of the company’s transactions.

40)

Which of the following is not true of "reasonable assurance"?

A) The auditors have exercised due care.

B) The audit opinion is a guarantee that material misstatements have been identified.

C) The audit has been properly planned and supervised.

D) The auditors have followed GAAS.

41)

Which of the following is not correct about materiality?

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A) the concept of materiality recognizes that some matters are more important for fair presentation of financial statements.

B) materiality judgments are made in light of surrounding circumstances and necessarily involve quantitative and qualitative judgments.

C) materiality should be predictable from audit to audit so that the readers of financial statements know what constitutes materiality.

D) an auditor's consideration of materiality is influenced by the auditor's perception of the needs of the readers of the financial statements.

42)

Which of the following is not a consideration in determining a measure of materiality?

A) risks of material misstatements due to fraud B) quantitative assessment of the importance of the difference of opinion with client management on accounting issues C) qualitative assessment of the importance of the difference of opinion with client management on accounting issues D) importance of audit committee in the organization

43) The SEC is concerned that auditors don't pay enough attention to qualitative factors affecting materiality because A) qualitative factors may cause quantitatively small misstatements to become material.

B) quantitative factors are not always useful.

C) quantitative factors cannot be accumulated to assess overall materiality.

D) All are of concern to the SEC.

44) on

The auditors' determination of whether the financial statements "present fairly" is based

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A) whether the users are able to assess the reliability of the financial statements.

B) whether the statements have been prepared in accordance with the same GAAP used from one year to another.

C) whether the auditor has been able to gather sufficient evidence to warrant the statement that the financial statements present fairly.

D) whether the accounting principles used are appropriate in the circumstances.

45)

Which of the following summarizes the essence of general responsibilities of GAAS?

A) quality of professionals that perform an audit B) criteria used to judge whether the audit has met quality requirements C) the standards that guide auditors in issuing the audit report D) whether the auditor obtained sufficient competent evidential matter to render an opinion

46)

Machine Based Learning systems provide all of the following benefits except A) analyze very large data sets quickly.

B) identify whether the auditor was independent in conducting the audit.

C) identify anomalies within the data.

D) revolutionize the ability of auditors to identify fraud within an organization.

47) Which of the following is not one of the reporting standards of GAAS that guides auditors in formulating the audit opinion?

A) the financial statements have followed GAAP B) consistency in the application of GAAP C) adequate disclosures exist in the statements D) gathering sufficient audit evidence to warrant an opinion

48) Because of the risk of material misstatement due to improper management representations, an audit of financial statements in accordance with GAAS should be performed with

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A) objective judgment.

B) professional skepticism.

C) internal controls.

D) due diligence.

49)

Gathering and objectively evaluating audit evidence requires the auditor to consider A) whether an unmodified opinion should be issued.

B) whether a modified opinion should be issued.

C) whether the evidence is adequate to complete the audit.

D) whether the evidence is competent and sufficient enough to render an audit opinion.

50)

In an audit, the auditor has a requirement to address risk assessment with respect to A) the design and performance of audit procedures to respond to assessed risks.

B) whether the standards close the expectation gap.

C) the role and responsibilities of the audit committee in preventing fraud.

D) ensuring that no fraud occurred for the period under audit.

51)

Audit procedures are different than audit evidence because

A) audit procedures address the competency and sufficiency of audit evidence.

B) audit procedures are specific acts performed by the auditor to gather evidence about whether specific assertions are being met.

C) audit procedures are specific acts to assess whether the financial statements "present fairly".

D) audit procedures do not have to be determined based on risk assessment.

52)

Audit documentation is critical to evidence gathering because

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A) it demonstrates that an audit has been conducted.

B) it demonstrates professional skepticism.

C) it substitutes for making audit judgments and estimates.

D) All of these choices are correct.

53) In the Statement of Financial Accounting Concepts (SFAC) No. 2. SFAC No. 2, the position about materiality is that A) it should always be determined only through qualitative evaluations.

B) it should always be determined through quantitative evaluations.

C) it should always be determined by considering whether the amount affects past financial statements.

D) it should be determined by how the magnitude of the item would be viewed by a reasonable person.

54)

The objective of an engagement quality review is to A) assess how an audit has been conducted and the appropriateness of the audit opinion.

B) assess the firm's own quality controls and the appropriateness of the audit opinion.

C) assess how an audit has been conducted and the firm's own quality control procedures.

D) assess whether materiality has been properly evaluated.

55)

The PCAOB addresses audit results and requires the

A) auditor's evaluation of internal controls.

B) auditor's determination of whether the auditor has obtained sufficient appropriate evidence.

C) auditor's evaluation of the applicable financial reporting framework.

D) auditor's independence.

56) Auditors are required to communicate with the audit committee for all but which of the following

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A) significant accounting policies and practices.

B) critical accounting practices and policies.

C) significant unusual transactions.

D) the procedures followed by the auditor in evaluating evidence.

57) Auditors are required to communicate with the audit committee all but which of the following A) going concern issues.

B) whether the auditor expects to modify the opinion.

C) any disagreements with management.

D) the procedures followed to comply with generally accepted auditing standards.

58)

In the Medicis audit, the auditors failed to complete all of the following except A) failed to issue an unqualified opinion.

B) failed to follow GAAS. C) failed to correct control deficiencies.

D) failed to obtain adequate evidence related to management representations.

59)

Which of the following is not a common audit deficiency in PCAOB inspections?

A) inadequate internal controls over financial reporting B) maintaining an independent audit C) lack of due care D) inability to exercise the appropriate level of professional skepticism

60) Limitations and concerns surrounding the use of AI in auditing include all the following except

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A) AI cannot see the big picture and is restricted only to the correct or incorrect data to which it has access.

B) AI classifies anomalies faster and better than the auditor completing the task manually.

C) Data integrity could be compromised if appropriate controls are not implemented or operating effectively.

D) AI cannot evaluate moral or ethical concerns.

61) to

In the Loyalty and Fraud Reporting case, Ethan Lester pressured his friend Vick Jensen

A) misappropriate funds from the company.

B) cover up Ethan's fraud.

C) be silent and not report Ethan's fraud to the audit committee.

D) give an unmodified audit report.

62)

In the ZZZZ best case, Barry Minkow was charged with A) a fraudulent insurance restoration scam B) insider trading on Lennar stock C) stealing from a San Diego church D) overcharging a LA housewife for carpet cleaning services

63) In the Reauditing Financial Statements case, all of the following would be appropriate questions to ask a predecessor auditor except A) why the predecessor auditor was fired.

B) whether there were any differences of opinion between management and the predecessor auditor.

C) whether they could obtain the predecessor auditor workpapers.

D) whether there were any integrity concerns of top management.

64)

The case which deals with assigning a quality review partner to an audit is

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A) ZZZZ Best B) Imperial Valley Community Bank.

C) Medicis Pharmaceutical.

D) Rooster, Hen, Footer, and Burger.

65)

The company that fabricated revenue using a technique called roundtripping was A) ZZZZ Best.

B) Wirecard.

C) Allergan.

D) Qwest Communications.

66)

The primary issue in the EP Sports case is

A) the timing of revenue recognition and early shipping of merchandise.

B) the use of an off-balance-sheet cash account to pay bonuses, entertainment expenses, and gifts to local government officials.

C) the timing of expense recognition on accrual accounts D) the use of non-GAAP metrics to deceive investors.

67)

Which of the following is not addressed in the Diamond Foods case?

A) accounting for payments to walnut growers B) matching revenues with the proper period C) depreciation of almond trees D) misleading the external auditors

68)

The ethical dilemma that faces Ronnie Maloney is best described as

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A) whether the loan loss reserves of the bank were understated.

B) whether to file a whistle-blower's complaint with the SEC under Dodd-Frank.

C) whether to commit fraud to cover up stealing from the company.

D) whether to properly inform the audit committee of critical audit matters.

69)

The primary accounting issue in the Weatherford International case is A) fraudulent recording of revenues on sales to customers.

B) fraudulent use of company resources by top management for personal purposes.

C) fraudulent inflation of earnings using deceptive income tax accounting.

D) fraudulent inflation of inventory to reduce losses on the income statement.

70) The term "true and fair view" tends to be a replacement for United States.

blank_ used in the

A) full and fair B) present fairly C) representational faithfulness D) economic substance

ESSAY. Write your answer in the space provided or on a separate sheet of paper.

71) Explain each of the three sides of the fraud triangle with respect to how it contributes toward the possibility that fraud in the financial statements may be present. Are there differences with respect to how each element might influence occupational fraud and fraudulent financial statements? Explain.

72) Explain the link between the opportunity to commit fraud and corporate governance systems.

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73) Explain the circumstances under which an auditor should give each of the following opinions: (a) Unmodified opinion (b) Unmodified opinion with an emphasis-of-matter paragraph (c) Qualified opinion (d) Adverse opinion

74) What is the purpose of having required auditor communications between the external auditor and the audit committee?

75) Why is materiality one of the most difficult judgments to make in auditing financial statements?

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76) Differentiate between the auditors' responsibilities to detect errors, fraud, and illegal acts.

How would you assess the ethics of a company that has experienced each event with respect to motivation and the integrity of those who go along with such events?

77) Internal controls, an internal audit function, and an audit committee are all elements of a strong corporate governance system. How should an external auditor evaluate these elements in making a risk assessment? What are the ethical signs that each system is operating as intended?

78) Campus Fast is a new audit client. Campus Fast uses public WiFi to place and deliver restaurant take out for students at the Up and Coming State University. Campus Fast was founded by three highly ambitious MBA students at the university. The business plan is to find a buyer or place an IPO of the company by graduation in two years. The founders expect to pay off all student loans, take a tour around the world, and then start another company. In order for the business plan to work on the timeline for graduation, the business must meet highly ambitious earnings numbers. Additionally, the company is dealing with two situations that the founders would like to keep from the auditors:

79) Differences exist between the AICPA unmodified report used for nonpublic companies’ audits and the PCAOB unqualified audit report. Identify the main differences between these reports.

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80) The PCAOB has expressed concern about “audit quality” and has made recommendations to the profession on ways in which they can improve the quality of the audits they conduct. The PCAOB Quality Control (QC) Section 20 standards for the System of Quality Control for a CPA Firm’s Accounting and Auditing Practice emphasizes that the Scope and Nature of Services Principle in the AICPA Code calls for CPAs to practice in firms that have in place internal quality-control procedures to ensure that services are competently delivered and adequately supervised. A firm’s system of quality control encompasses the firm’s organizational structure and the policies adopted and procedures established to provide the firm with reasonable assurance of complying with professional standards.

81)

Discuss all the factors an auditor should consider in making a materiality judgment.

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Answer Key Test name: Chap 05_6e_ Mintz 1) D 2) A 3) A 4) D 5) B 6) B 7) C 8) D 9) D 10) A 11) C 12) B 13) C 14) B 15) D 16) C 17) C 18) A 19) C 20) A 21) D 22) C 23) A 24) B 25) C 26) D Version 1

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27) B 28) C 29) B 30) D 31) A 32) A 33) D 34) B 35) B 36) C 37) C 38) B 39) B 40) B 41) C 42) D 43) A 44) D 45) A 46) B 47) D 48) B 49) D 50) A 51) B 52) B 53) D 54) C 55) B 56) D Version 1

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57) D 58) A 59) B 60) B 61) B 62) A 63) C 64) C 65) B 66) B 67) C 68) D 69) C 70) B

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71)One of the older and more basic concepts in fraud deterrence and detection is the "fraud triangle." While researching his doctoral thesis in the 1950s, famed criminologist Donald R. Cressey came up with this hypothesis to explain why people commit fraud.

The three key elements in the fraud triangle are opportunity, motivation, and rationalization. Opportunity is the element over which business owners have the most control. Limiting opportunities for fraud is one way a company can reduce it.

The opportunity to commit fraud is possible when employees have access to assets and information that allows them to both commit and conceal fraud, typically because of weak internal controls including a lack of segregation of duties or oversight. Top management typically overrides the controls when committing financial statements fraud while employees may use the weaknesses to their advantage in perpetrating fraud.

Motivation is a pressure or a "need" felt by the person who commits fraud. It might be a personal financial or other type of need, such as high medical bills or debts, or as a result of bad personal habits as occurred in ZZZZ Best and Tyco where CEOs misappropriated company resources for personal gain.

Motivators can also be financially oriented to affect business results.

Pressures may exist to meet or exceed financial analysts' earnings estimates or to qualify for high bonuses and/or to inflate share prices and make stock options more valuable.

Lastly, employees may rationalize this behavior by determining that committing fraud is OK for a variety of reasons. For those who are generally dishonest, it's probably easier to rationalize a fraud. For those with higher moral standards, it's probably not so easy. They have to convince themselves that fraud is OK with "excuses" for their behavior.

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replacing a bonus that was deserved but not received. A thief may convince himself that he is just "borrowing" money from the company and will pay it back one day. Some embezzlers tell themselves that the company doesn't need the money or won't miss the assets. Others believe that the company "deserves" to have money stolen because of bad acts against employees.

Business owners and executives must take control of fraud by working on the portion of the fraud triangle over which they have the most control: the opportunity to commit fraud. It may be difficult for management to do anything about an employee's needs or rationalizations, but by limiting opportunities for fraud, the company can reduce it to some extent.

This question provides an opportunity to review the GVV reasons and rationalizations framework.

As you read the case, think about the following series of questions for the protagonist to address after identifying the right thing to do including: ● How can they get it done effectively and efficiently? ● What do they need to say, to whom, and in what sequence? ● What will the objections or push-back be and, then, ● What would they say next? What data and examples do they need?

To assist you in the process of analyzing what actions should be taken by the protagonist, here are the most frequent categories of argument or rationalization that we face when we speak out against unethical practice.

Expected or Standard Practice: "Everyone does this, so it's really standard practice. It's even expected."

Materiality: "The impact of this action is not material. It doesn't really hurt anyone."

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following orders here."

Locus of Loyalty: "I know this isn't quite fair to the stakeholders, but I don't want to hurt my reports/team/boss/company."

Isolated Incident: "This is a one-time request; you won't be asked to do it again."

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72)An important factor in whether the opportunity to commit fraud exists is whether the corporate governance system is operating as intended. If not, the opportunity to commit fraud is greater. In cases such as Tyco, the board members were allowed to use company funds for personal purposes to bring them along with the CEO's similar fraud (Dennis Kozlowski), and presumably to buy their silence.

Prior to SOX, most boards of directors were not independent of management and, in many cases including Tyco, board members were beholden to management for their positions. It was highly unlikely the board served as a check on unethical behavior or fraudulent financial statements. SOX requires an independent audit committee with one member being a financial expert. The New York Stock Exchange requires a majority of board members to be independent of management.

These outside directors should meet separately with the internal auditors and external auditors to get candid comments about management's performance, whether the internal controls are operating as intended, and whether the financial statements are accurate and reliable. PCAOB Standard No. 16 also requires specific communications between the external auditors and the audit committee. Corporate governance has been tightened up in almost all companies thereby making it less likely that, at least in the corporate governance arena, the opportunity will exist to commit fraud.

Another factor that influences opportunity is organizational dissonance.

Dissonance creates an unhealthy organizational culture that can lead to fraud because employees so affected feel more justified in committing fraud. When organizational ethics are low and an individual's ethics are low, fraud is more likely to occur. On the other hand, if organizational ethics are high while an individual's are low, there must be mechanisms built into the corporate governance system such as a hot line and/or compliance officer to monitor ethical systems. Other employees should Version 1

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be encouraged to speak up when they notice another employee violating ethical standards. The hot line helps in that regard.

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73)Unmodified Opinion Unmodified opinions are given when the financial statements present fairly financial position and results of operations in accordance with GAAP and there are no material misstatements that need to be corrected to conform to GAAP. Unmodified opinion with an emphasis-of-matter paragraph An emphasis-of-matter issue arises when questions exist about the going concern nature of a client's operations perhaps because of a declining level of earnings, lack of adequate cash flows to meet operating needs, and/or the inability of the client to raise needed funds. When a going concern issue exists, the auditor should address management's plans to overcome the problem in the future in the audit report.

An emphasis of matter issue also exists when GAAP have not been consistently applied. For example, if a company changes the way they account for capitalized costs, such as capitalizing them in one year and then expensing them in another, the change should be disclosed as well as its effects of the financial results. Auditors should approve such changes; otherwise, a modified opinion may be necessary.

Qualified opinion A qualified opinion is generally given when a departure exists from GAAP that has a material effect on the financial statements. The amount must be material but event(s) not pervasive enough to issue an adverse opinion. If, in the previous example, a company was capitalizing costs instead of expensing them in order to improve earnings, then a GAAP deficiency exists and should be disclosed if it has a material effect on the financial statements. GAAP issues are disclosed in the audit report with language "except for the GAAP departure…the financial statements present fairly…"

A qualified opinion also may be necessary when a scope limitation exists that prevents the auditor from evaluating whether a GAAP Version 1

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deficiency exists. In such cases the language would be "except for the scope limitation…the financial statements present fairly…"

Adverse opinion An adverse opinion means the financial statements do not present fairly financial position and results of operations because material differences exist on GAAP matters that have a pervasive effect on the financial statements. For example, inventory differences over a period of time will affect both the balance sheet and income statements through both the beginning and ending inventories. If two or more differences on GAAP matters exist, then the effects also may be pervasive. When such differences exist, the reasons for the adverse opinion must be given.

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74)The audit committee helps those charged with governance fulfill their oversight responsibilities with respect to the entity's financial reporting process and the system of internal control. In exercising this oversight responsibility, the audit committee needs information from the external auditors about their experiences assessing internal controls and corporate governance as well as any issues faced during their audit that involve differences with management on financial reporting issues. The audit committee should support the external auditors in their role to ensure the examination of the financial statements proceeds as required under generally accepted auditing and PCAOB standards. The audit committee serves as a check on ethical systems in the organization.

The PCAOB has no jurisdiction over audit committees, so PCAOB Auditing Standard 16, Communications with Audit Committees, has requirements which are aimed strictly at external auditors. The standard requires auditors to: ● Establish the understanding of the terms of the audit engagement with the audit committee. The terms of the engagement must be recorded in an engagement letter. ● Provide audit committees with an overview of the overall audit strategy, including the timing of the audit, significant risks the auditor identified, and significant changes to the planned audit strategy or risks. ● Provide information about others involved in the audit, including internal auditors or other independent public accounting firms. ● Give information regarding the company's accounting policies, practices, estimates, and significant unusual transactions. ● Provide an evaluation of the quality of the company's financial reporting, including conclusions regarding critical accounting estimates and the company's financial statement presentation; difficult or contentious matters for which the auditor consulted outside the engagement team; the auditor's evaluation of the company's ability to Version 1

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continue as a going concern; and difficulties encountered in performing the audit.

Given the importance of an independent audit in detecting fraud in financial statements, the auditor should discuss with the audit committee relationships that create threats to auditor independence and the related safeguards that have been applied to eliminate or reduce those threats to an acceptable level.

Another important area for communication is about accounting estimates. Certain accounting estimates are particularly sensitive because of their significance to the financial statements and because of the possibility that future events affecting them may differ significantly from management's current judgments. In communicating with those charged with governance about the process used by management in formulating sensitive estimates, including fair value estimates, and about the basis for the auditor's conclusions regarding the reasonableness of those estimates, the auditor should consider the following: ● The nature of significant assumptions ● The degree of subjectivity involved in the development of the assumptions, and ● The relative materiality of the items being measured to the financial statements as a whole If the auditor, as a result of the assessment of the risks of material misstatement, has identified such risks due to fraud that have continuing control implications the auditor should consider whether these risks represent significant deficiencies or material weaknesses in the entity's internal controls that should be communicated to management and those charged with governance. The auditor should also consider whether the absence of or deficiencies in controls to prevent, deter, and detect fraud represent significant deficiencies or material weaknesses that should be communicated to management and those charged with governance.

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75)Materiality underlies financial statement assertions and has a pervasive effect in a financial statement audit. In conducting an audit, the auditor should consider materiality in planning the audit and in evaluating the fair presentation of the financial statements in accordance with an identified financial reporting framework.

The determination of materiality is a matter of professional judgment. In determining the materiality of an item, the auditor considers not only the item's nature and amount relative to the financial statements, but also the needs of financial statement users.

Materiality has to be considered before a detailed audit program can be prepared. In the initial planning, however, an auditor cannot anticipate all of the factors that will ultimately influence the materiality judgment in the evaluation of audit results at the completion of the audit.

Therefore, these factors must be considered as they arise, and materiality must be evaluated throughout the audit.

Materiality has significant implications for audit efficiency. To be efficient, an auditor should not spend time examining balances where there is no chance of a material error. Sometimes, in an audit of a small entity, there is a temptation to audit everything because it does not seem as though it will take much time when individual items are considered.

The unnecessary time can, however, add up to a significant amount overall.

Material information means information that matters, is important or essential. In terms of accounting, it pertains to information that is to be recognized, measured, or disclosed in accordance with the requirements of generally accepted accounting principles. In measuring or disclosing accounting information, emphasis is on the needs of known or perceived users. In auditing, materiality pertains to the largest number (threshold) of uncorrected errors, misstatements, or erroneous disclosures or omissions that exist in the financial statements and yet are not Version 1

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misleading. The auditor plans and executes an audit with a reasonable expectation of detecting material misstatements. The assessment of what is material is a matter of the auditor's professional judgement of the needs of the reasonable person relying on the information.

Financial statements are materially misstated when they contain errors or irregularities whose effect, individually or in the aggregate, is important enough to prevent the statements from being presented fairly in accordance with GAAP. In this context, misstatements may result from misapplication of applicable accounting standards, departures from fact, or omissions of necessary information.

In assessing the quantitative importance of a misstatement, it is necessary to relate the monetary amount of the error to the financial statement under examination. For example, an item of revenue may be compared to net income for materiality determinations. In planning the examination, the auditor generally is concerned only with misstatements that are quantitatively material. In evaluating audit evidence, the auditor considers both quantitative and qualitative misstatements.

There is no universally agreed upon guideline on quantitative measures of materiality. Here is an example of making materiality determinations: 1.An amount which is equal to or greater than 10 percent of an appropriate base amount is presumed to be material.

2. An amount which is equal to or less than 5 percent of an appropriate base amount may be presumed not to be material.

3. To determine whether an amount between 5 percent and 10 percent is material is a matter of judgment.

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qualitatively material. This may occur, for instance, when the misstatement is attributable to an irregularity or an illegal act by the client. Discovery of either occurrence might cause the auditor to conclude there is a significant risk of additional similar misstatements.

Other examples of qualitative misstatements are found in Staff Accounting Bulletin (SAB 99). In it, the SEC lists some of the qualitative factors that may cause a quantitatively small misstatement to become material, including: ● It arises from an item capable of precise measurement. ● It arises from an estimate and, if so, the degree of imprecision inherent in the estimate. ● It masks a change in earnings or other trends. ● It hides a failure to meet analysts' consensus expectations for the enterprise. ● It changes a loss into income or vice versa. ● It concerns a segment or other portion of the registrant's business that has been identified as playing a significant role in the registrant's operations or profitability. ● It affects the registrant's compliance with regulatory requirements. ● It affects the registrant's compliance with loan covenants or other contractual requirements. ● It has the effect of increasing management's compensation—for example, by satisfying the requirements for the award of bonuses or other forms of incentive compensation. ● It involves concealment of an unlawful transaction.

Auditors should be on the alert for these red flags, which signal that qualitatively material items may not have been recorded and disclosed in accordance with GAAP.

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76)An error can occur due to unintentional misstatements or omissions of amounts or disclosures in the financial statements. Errors may involve mistakes in gathering or processing data, unreasonable accounting estimates arising from oversight or misinterpretation of facts, or mistakes in the application of GAAP. Auditors are responsible for detecting errors that have a material effect on the financial statements and reporting their findings to the audit committee. Errors are typically recorded by adjusting the opening balance of retained earnings for the prior period adjustment to net income.

Errors are unintentional. No one makes an error on purpose because it negatively reflects on one's abilities. As long as the person causing the error admits it, takes responsibility for her actions, and promises to be more careful in the future, the ethics of making an error are not in question.

Fraud is a deliberate act intended to deceive others. Fraud does not happen by accident as might an error. Auditors should be sensitive to red flags that warn fraud is possible, if not likely. Fraud, whether fraudulent financial reporting or misappropriation of assets, involves incentive or pressure to commit fraud, a perceived opportunity to do so, and some rationalization of the act. A fraud occurs when an individual(s) in management, those charged with governance, employees or third parties, use deception in a way that results in a material misstatement in the financial statements. In its most common form, management fraud involves top management's deceptive manipulation of financial statements.

Fraud is a deceptive act and as such an unethical act. It is based on egoism without regard for the interests of those affected by the fraud such as shareholders and investors. Those who commit fraud are engaging in an illegal act and may be prosecuted for their actions. The internal controls of an organization should be designed to ferret out Version 1

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fraud by looking for the red flags and dealing with ethical pressures within the organization.

Illegal acts are violations of laws or governmental regulations. For example, a violation of the Foreign Corrupt Practices Act (FCPA) that prohibits bribery constitutes an illegal act. Illegal acts include those attributable to the entity whose financial statements are under audit or as acts by management or employees acting on behalf of the entity. The auditor's responsibility is to determine the proper accounting and financial reporting treatment of a violation once it has been determined that a violation has in fact occurred.

Illegal acts not only violate specific laws but are clear violations of ethical behavior. The auditor's responsibility is to detect and report misstatements resulting from illegal acts that have a direct and material effect on the determination of financial statement amounts (i.e., they require an accounting entry). The auditor’s responsibility for detecting direct and material effect violations is greater than their responsibility to detect illegal acts arising from laws that only indirectly affect the client's financial statements. An example of the former would be violations of tax laws that affect accruals and the amount recognized as income tax liability for the period. Tax law would be violated, triggering an adjustment in the current period financial statements if, say, a company, for tax purposes, were to expense an item all in one year that should have been capitalized and written off over three years. Examples of items with an indirect effect on the statements include the potential violation of other laws such as occupational safety and health, environmental protection, and equal employment regulations. The events are due to operational, not financial, matters and their financial statement effect is indirect, such as a possible contingent liability that should be disclosed in the notes to the financial statements.

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likely to have occurred is first to assess the impact of the actions on the financial statements including materiality considerations. This should be done regardless of any direct or indirect effect on the statements. The auditor should consult with legal counsel and any other specialists in this regard. Illegal acts should be reported to those charged with governance such as the audit committee. The auditor should consider whether the client has taken appropriate remedial action concerning the act. Such remedial action may include taking disciplinary actions, establishing controls to safeguard against recurrence, and, if necessary, reporting the effects of the illegal acts in the financial statements. Ordinarily, if the client does not take the remedial action deemed necessary by the auditor, then the auditor should withdraw from the engagement. This action on the part of the auditor makes clear that she will not be associated in any way with illegal activities.

The auditor should assure herself that the audit committee is informed as soon as practicable and prior to the issuance of the auditor's report with respect to illegal acts that come to the auditor's attention. The auditor need not communicate matters that are clearly inconsequential and may reach agreement in advance with the audit committee on the nature of such matters to be communicated. The communication should describe the act, the circumstances of its occurrence, and the effect on the financial statements.

The standards for reporting illegal acts seem to err on the side of protecting the auditor's position in a legal matter rather than strict honesty because certain items can be ignored even though they violate the law. Honesty requires that we should express the truth as we know it and without deception. As we point out in the text, it is our belief that by leaving out truthful (inconsequential) information in auditor communications, the standards sanction unethical behavior. We believe that it is a slippery slope once distinctions are made as to whether acts Version 1

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that are inherently wrong by their nature are not reported. Moreover, even inconsequential items can become consequential if the pattern of misstatement persists.

The Private Securities Litigation Reform Act (PSLRA) of 1995 places additional requirements upon public companies registered with the SEC and their auditors when (1) the illegal act has a material effect on the financial statements, (2) senior management and the board of directors have not taken appropriate remedial action, and (3) the failure to take remedial action is reasonably expected to warrant departure from a standard (i.e., unmodified audit report) or to warrant resignation.

When the auditor believes that the illegal act has a material effect on the financial statements and the matter has been reported to the client, the board of directors has one business day to inform the SEC. If the board decides not to inform the SEC, the auditor must provide the same report to the SEC within one business day or resign from the engagement within one business day. In either case, the ethical obligation of confidentiality is waived so that the auditor can provide the necessary information and the SEC can live up to its responsibility to protect investor interests. If auditors do not fulfill this legal obligation, the SEC can impose a monetary fine on them.

Notwithstanding the reporting obligations described above, disclosure of an illegal act to parties other than the client's senior management and its audit committee or board of directors is not ordinarily part of the auditor's responsibility, and such disclosure would be precluded by the auditor's ethical or legal obligation of confidentiality, unless the matter affects his opinion on the financial statements.

This is a good time to remind students of Exhibit 5.1 in the text that summarizes auditors' responsibilities with respect to reporting errors, illegal acts, and fraud.

Exhibit 5.1

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Auditors’ Responsibility to Detect Errors, Illegal Acts, and Fraud Responsible for Detection Material

Required to Communicate Findings Immaterial Material

Immaterial

Errors

Yes

No

Yes (audit committee)

No

Illegal acts

Yes (direct No effect)

Yes (audit committee)

Yes (one level above)

Fraud

Yes

Yes (audit committee)

Yes (by low-level employee, to one level above) (by managementlevel employee, to audit committee)

No

77)The internal audit function should be an independent one with direct links between the internal auditors and audit committee so that top management does not have the opportunity to interfere in the reporting process. The ethical values of due care, responsibility, and accountability support an independent internal audit committee function.

Internal controls should provide the foundation for proper accounting and reporting by establishing a control environment that fosters an ethical culture through the tone at the top set by management. Top management should promote honesty and integrity in the financial reporting systems. The corporate governance system establishes how matters of concern will be handled within the organization and with the external auditors. There should be clear communication lines within the organization for the internal auditors. The audit committee should be informed and actively involved in overseeing the financial reporting process. Risk assessment depends on the strength of these systems and whether they are operating as intended.

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78)1) The company has been using free, unsecured public WiFi to take orders via the Internet. The customer may pay via the Internet. Several students, who all happen to be members of the same student organization on campus, are claiming that using Campus Fast has allowed their identity to be stolen. One student is claiming that she had $12,000 of charges on her credit card to the unsecured Internet site of Campus Fast. Management plans to pay off the complaining students and keep the true liability off the balance sheet. The reason is Campus Fast is concerned that an interested buyer may become concerned about the unsecured site and might get scared by the student complaints.

2) The company guarantees fast delivery. It has offered to pay any speeding or other moving violation tickets to its delivery drivers.

Unfortunately, one of the drivers was involved in an accident due to running a red light. The passenger in the other car is in critical condition and the intensive care unit in the hospital. The driver has promised the family of the passenger that the company will make good on any expenses and admitted the company policy on repaying all traffic tickets.

Attorneys for the injured party are threatening to sue and publicize the situation. The founders do not have enough cash to take care of this problem but are still trying to keep the situation from the auditors and potential buyer.

Using the internal control framework assesses the internal controls at Campus Fast and risk environment.

The students should discuss the control environment of Campus Fast (founders' intent on making goals) risk assessment (two potential contingent and actual liabilities that the founders are trying to cover up and keep off the balance sheet), control activities, information and communications systems (liability of using unsecured WiFi), and monitoring. Corporate governance issues exist although we do not know whether oversight mechanisms were in place to serve as a check on Version 1

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management behavior.

This is a case where the two students suffered from ethical blindness.

They did not consider that their policies and practices had (negative) consequences for the stakeholders and cutting corners to achieve a goal is never a good idea. There appears to be no oversight of the internal controls. The culture of the company seems to be do whatever it takes to grow and become an attractive IPO candidate. The owners are acting out of egoism and practicing dangerous advertising and delivery systems. It could be that the culture filters down to the workers who are careless in making deliveries and, perhaps, with Internet activity.

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79) ● The PCAOB report is titled Report of Independent Registered

Public Accounting Firm, and the AICPA report is titled Report on the Audit of Financial Statements. ● Reference to whether the financial statements are free of material misstatement, whether due to error or fraud, appears in the Basis for Opinion section of the PCAOB report, but in a separate section titled Auditor’s Responsibility for the Audit of the Financial Statements in the AICPA report. ● The PCAOB report language specifically references the independence requirement under relevant laws and rules of the SEC and PCAOB in the Basis for Opinion Section; the AICPA report in the Basis of Opinion section references both a requirement for independence, and of meeting other ethical responsibilities, in accordance with the relevant ethical requirements relating to audits. The PCAOB report is silent as to ethics. ● The AICPA report specifically references considering the internal controls in order to design audit procedure but not to express an opinion; the PCAOB report doesn’t specifically mention internal controls but addresses the role of audit procedures. The internal control report of management is required for public companies as a separate report by SOX Section 404. ● The PCAOB report that was revised on June 1, 2017, now includes a separate section on Critical Audit Matters (CAMs) that are not included in the AICPA report. However, an auditor can be hired to report on Key Audit Matters (KAMs) in conjunction with the audit of a privately held company in accordance with AU-C 701. CAMs are similar to, but not identical to KAMs. ● The PCAOB report includes a statement disclosing the year in which the auditor began serving consecutively as the company’s auditor; no such statement exists in the AICPA report.

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80) Required:

Comment on the need for audit quality indicators and any limitations of providing such information in the public domain.

Quality control includes the maintenance of Integrity, Objectivity, performing the audit with Professional Skepticism, Due Care, and Independence, which requires a continuing assessment of client relationships, engagement performance, and monitoring. This encompasses the values, ethics, and attitudes of auditors, which in turn are influenced by the culture of the audit firm. In addition, a new requirement for PCAOB reports is for the auditor to determine and communicate “critical audit matters.”

The 2019 PCAOB overview report highlighted the following good audit practices: Recommendation Interactive meetings/coaching workshops

Description Includes entire engagement team, often tied to audit milestones

Early involvement of engagement quality reviewer (EQR)

From audit planning stage forward

Result Identifying how financials might be materially misstated Identifying risks of material misstatement May result in in early identification of potential or actual audit challenges Used to monitor engagement performance and enhance the audit effectiveness

Firms created narratives of their quality control process or prepared process flow maps of them Increased partner Engagement team Discussions and robust involvement in planning leadership held risk assessment of audit tests and planning meetings procedures improve staff controls with whole engagement ability to analyze team effectiveness of controls Use of firm specialists Early involvement of Enhances the ability of during audit planning to specialists during auditors to more assist in risk audit planning stage effectively identify and Narrative descriptions of quality control

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assessment

assess risks of material misstatement

Implementing coaching Targeting areas where Noted improvement in the programs and refining the firms have had auditing of estimates at audit tools for specific audit deficiencies in firms that implemented audit areas the past these programs

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81) The principle of materiality underscores the concept that some

financial transactions are so insignificant that they are not worth measuring and reporting with exact precision. For example, some companies may define an item as material only if it affects earnings by more than 5 percent to 10 percent. This principle allows for some judgment and flexibility in financial reporting. One approach would be to consider items below 5 percent as immaterial; over 10 percent as material; and between 5 and 10 percent dependent on motivation where professional judgment is needed to make that determination. One problem with quantitative measures is a company could manipulate revenues or expenses deliberately, and yet do so within an established maximum percentage of acceptability and claim that the misstatement is not material.

The concept of "materiality" is important in securities law. Whether in a registration statement, or in a filing under the 1934 Act, or in providing information to the trading markets, a company will be liable for any material misstatement, or any material omission of facts necessary to make other statements "not misleading."

The basic accounting standard for materiality judgments is in Statement of Financial Accounting Concepts (SFAC) No. 2. SFAC No. 2 provides that: “The omission or misstatement of an item in a financial report is material if, in the light of surrounding circumstances, the magnitude of the item is such that it is probable that the judgment of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.”

SOX increased demands on management to prevent and detect material internal control weaknesses. To develop the controls, SOX requires that auditors need to be able to identify key control exceptions and apply a materiality concept to determine the financial impact of such exceptions.

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their responsibilities under SOX, including: (1) the actual financial statement misstatement or error, (2) an internal control deficiency caused by the failure in design or operation of a control, (3) a large variance in an accounting estimate compared with the actual determined amount, and (4) financial fraud by management or other employees to enhance a company's reported financial position and operating results.

In Staff Accounting Bulletin (SAB) No. 99, the SEC noted that qualitative factors may cause misstatements of quantitatively small amounts to be material. As a result of the interaction of quantitative and qualitative considerations in materiality judgments, misstatements of relatively small amounts that come to the auditor's attention could have a material effect on the financial statements.

Among the considerations that may well render material a quantitatively small misstatement of a financial statement item are: ● Whether the misstatement arises from an item capable of precise measurement or whether it arises from an estimate and, if so, the degree of imprecision inherent in the estimate ● Whether the misstatement masks a change in earnings or other trends ● Whether the misstatement hides a failure to meet analysts' consensus expectations for the enterprise ● Whether the misstatement changes a loss into income or vice versa ● Whether the misstatement concerns a segment or other portion of the registrant's business that has been identified as playing a significant role in the registrant's operations or profitability ● Whether the misstatement affects the registrant's compliance with regulatory requirements ● Whether the misstatement affects the registrant's compliance with loan covenants or other contractual requirements ● Whether the misstatement has the effect of increasing management's compensation—for example, by satisfying requirements for the award of Version 1

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bonuses or other forms of incentive compensation ● Whether the misstatement involves concealment of an unlawful transaction.

When management or the independent auditor expects (based, for example, on a pattern of market performance) that a known misstatement may result in a significant positive or negative market reaction, that expected reaction should be taken into account when considering whether a misstatement is material.

The SEC believes that a registrant and the auditors of its financial statements should not assume that even small intentional misstatements in financial statements, for example, those pursuant to actions to "manage" earnings, are immaterial. While the intent of management does not render a misstatement material, it may provide significant evidence of materiality. The evidence may be particularly compelling where management has intentionally misstated items in the financial statements to "manage" reported earnings. In that instance, it presumably has done so believing that the resulting amounts and trends would be significant to users of the registrant's financial statements. The SEC believes that investors generally would regard as significant a management practice to over- or under-state earnings up to an amount just short of a percentage threshold in order to "manage" earnings.

Investors presumably also would regard as significant an accounting practice that, in essence, rendered all earnings figures subject to a management-directed margin of misstatement.

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Chapter 6: Motivation for Fraudulent Financial Reporting MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

1) Who linked earnings management to an excessive zeal to project smoother earnings from year to year that casts a pall over the quality of the underlying numbers?

A) Warren Buffet B) Arthur Levitt C) Thomas E. McKee D) Lynn Turner

2)

Which of the following is not a motivation to manage earnings?

A) companies try to meet or beat Wall Street earnings projections in order to grow market capitalization and increase the value of stock options B) to avoid the consequences of violating debt covenants C) to smooth net income over time D) to maximize employee bonuses

3)

An unusual aspect of the Green Mountain case is it included

A) conference calls that provided earnings guidance to shareholders and analysts were used to mask a financial fraud.

B) desire to meet or beat analysts' earnings expectations led to manipulation of receivables balances.

C) company violated the Sarbanes-Oxley Act. D) pricewaterhouseCoopers knew about inflated inventory values.

4) What is the SEC's position on companies that communicate with investors on social media?

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A) It is illegal to do so.

B) It is legal so long as companies inform investors which outlets they intend to use.

C) It is legal so long as the postings are restricted to Facebook.

D) There are no limitations on companies communicating through social media.

5) Which of the following has not been found to be a measure of a non-GAAP financial metric?

A) earnings before depreciation and amortization B) operating income before certain non-recurring expense or revenue items C) EBITDA D) GAAP earnings

6)

Motivations to smooth net income over time include each of the following except A) maximize bonuses and stock option values.

B) steady increase in earnings each year.

C) minimize overall taxes.

D) make it appear managers are doing better than they really are.

7)

A common method used to smooth net income over time is A) accelerating revenue into earlier periods.

B) delaying expenses into later periods.

C) using accrual of operating expenses and future adjustments.

D) using nonrecurring items to increase earnings in one year and reduce it later on.

8) If a company is managing its earnings, which of the ethical theories are they most likely following?

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A) rights B) fairness C) egoism D) virtue

9)

Which of the following is not considered "earnings management"?

A) "Earnings management" is done to project smoother earnings from year to year.

B) Management emphasizes achieving long-term results to meet financial goals.

C) Management uses "cookie-jar reserves each year".

D) Executives manipulate the earnings in order to match their predetermined target.

10) Which technique was used by both WorldCom and Waste Management to manage earnings?

A) manipulating asset net valuation amounts to minimize operating expenses for a period B) accelerating the recording of revenue into an earlier period C) delaying needed repairs to a later period D) All of these choices were used.

11) Which of the following author(s) emphasize(s) a "purposeful intervention in the external reporting process, with the intent of obtaining some private gain"?

A) Dechow and Skinner B) Healy and Wahlen C) Schipper D) Thomas E. McKee

12) Which of the following authors(s) focus(es) on "management's intent to deceive the stakeholders by using accounting devices to positively influence reported earnings"?

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A) Dechow and Skinner B) Healy and Wahlen C) Schipper D) Thomas E. McKee

13) Which of the following author(s) link earnings management to choices made in determining earnings that may comprise aggressive, but acceptable, accounting estimates and judgments, as compared to fraudulent practices that are clearly intended to deceive others?

A) Dechow and Skinner B) Healy and Wahlen C) Schipper D) Thomas E. McKee

14) Which of the following author(s) define(s) earnings management as "reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results"?

A) Dechow and Skinner B) Healy and Wahlen C) Schipper D) Thomas E. McKee

15)

Who distinguished between earnings manipulation and earnings management?

A) Hopwood et al.

B) Thomas E. McKee C) Arthur Levitt D) Belverd Needles

16)

One result of earnings management is

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A) it brings into question the quality of earnings.

B) it uses a non-GAAP financial measure to manipulate earnings.

C) EBITDA does not reflect GAAP earnings.

D) it improves shareholder returns over time.

17) In the Bruns and Merchant survey of managers, which technique to manage earnings was considered most acceptable?

A) changing inventory valuation in order to influence earnings B) accounting manipulation C) manipulating operating decisions D) establishing cookie jar reserves

18) Needles suggests that making judgments about what earnings management is becomes difficult because A) it depends on management's intentions.

B) there is no clear limit beyond which a choice is clearly unethical.

C) a perfectly routine accounting estimate may be illegal and unethical.

D) All of these choices are correct.

19) Each of the following is a finding of a survey of CFOs about their perceptions of earnings quality except A) CFOs believe that earnings are high quality when they are sustainable and backed by actual cash flows.

B) CFOs believe that earnings are high quality when they make consistent reporting choices over time.

C) CFOs believe key elements of earnings quality are transparency and predictability.

D) CFOs estimate that income increasing and income decreasing devices to manage earnings show a 50:50 split.

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20) Accruals that are based on estimated changes in fundamental economic performance of the firm are A) discretionary accruals.

B) nondiscretionary accruals.

C) operating accruals.

D) cookie jar accruals.

21)

Accruals are potentially troublesome because

A) they can lead to giving an unmodified audit opinion when it should have been modified.

B) they provide an opportunity to manage earnings through aggressive or more conservative estimations.

C) they always lead to fraud in financial statements.

D) they provide an opportunity to shift debt off the books by setting up an SPE.

22)

The main difference between a discretionary and nondiscretionary accrual is A) discretionary accruals are items that management has full control over.

B) discretionary accruals are based on changes in the fundamental performance of the

firm.

C) discretionary accruals arise from transactions considered normal for the firm.

D) discretionary accruals always lead to an increase in earnings.

23) The concept that earnings management might align with conservative versus aggressive reporting is known as the A) earnings judgment.

B) earnings accruals.

C) earnings continuum.

D) earnings manipulations.

24)

Which of the following is not a qualitative factor when assessing materiality?

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A) a misstatement that changes a loss into income or vice versa B) the existence of statutory or regulator reporting requirements that affect materiality thresholds C) the potential effect of the misstatement on trends, especially trends in profitability D) the use of simplistic numerical thresholds and rules of thumb

25) by

During the period of 1986-1995, the failures at savings and loan institutions were caused

A) stealing $300 million from shareholders.

B) questionable home mortgage loans and risky investments.

C) creating cookie jar reserves.

D) engaging in a Ponzi scheme.

26) Which term describes information given by management to provide investors and financial analysts data that indicates expected future earnings, earnings per share, and other items A) earnings judgment.

B) earnings accruals.

C) earnings guidance.

D) earnings continuum.

27) Which of the following is not a common location to find forward-looking earnings guidance?

A) management Discussion and Analysis (MD&A) B) social media C) the balance sheet D) press releases.

28) Which legislation provides a safe harbor when issuing forward-looking statements in SEC filings, press releases, investor presentations, and other public statements?

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A) Private Securities Litigation Reform Act B) Sarbanes Oxley C) Dodd-Frank D) Securities Exchange Act

29) When considering forward-looking guidance, the audit committee should understand management's processes for all of the following except A) developing assumptions and estimates.

B) accumulating guidance information.

C) hiring and training personnel.

D) ensuring management judgments are reasonable.

30)

"Cookie jar reserves" can best be described as

A) buying a lot of chocolate chip cookies, storing them for when you have a hunger attack, and then releasing them into your stomach.

B) overstating or understating allowances and reversing amounts in the future to smooth out net income over time.

C) accelerating the recording of revenues into an earlier year than is warranted.

D) delaying the recording of expenses to a later year to boost income in the current year.

31) All of the following are examples of "Recording revenue too soon or of questionable quality" except A) recording sales that lack economic substance.

B) recording revenue when future services remain to be provided.

C) recording revenue before shipment or before the customer's unconditional acceptance.

D) recording revenue even though the customer is not obligated to pay.

32)

All of the following are examples of "Boosting Income with One-Time Gains" except

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A) recording sales that lack economic substance.

B) boosting profits by selling undervalued assets.

C) including investment income or gains as part of revenue.

D) including investment income or gains as a reduction in operating expenses.

33)

Auditors need to be attuned to the red flags that fraud may exist because

A) materiality judgments are based on red flags identifying possible material misstatements.

B) audit opinions must be withdrawn when red flags indicate fraud may exist.

C) overly-aggressive accounting and outright manipulation of earnings may exist.

D) All of these choices are correct.

34) Which of the following was not pointed to by the SEC as a motivation for fraud in the Xerox case?

A) Xerox misled investors by polishing its reputation on Wall Street and to boost the company's stock price.

B) Xerox top management overrode the internal control to manipulate earnings.

C) Xerox failed to disclose GAAP violations that led to acceleration in the recognition of approximately $3 billion in equipment revenues.

D) Xerox recognized a greater amount of revenue on leases in early years than warranted and didn't break out revenues that should have been deferred and recognized in future years.

35) Which of the following earnings management techniques were not used in the Lucent Technologies, Income's case?

A) shifting current revenue to a later period B) boosting income with one-time gains C) recording revenue too soon or of questionable quality D) shifting current expenses to a later or earlier period

36)

Which of the following was not true according to the Enron case?

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A) Fastow developed the concept of buying up oil and gas companies to establish SPEs. B) Fastow worked to structure ventures that met the conditions under GAAP to keep the partnership activities off Enron's books and on the separate books of the partnership.

C) Fastow created SPEs that borrowed money from banks and transferred it to Enron in a sale of an operating asset no longer need by Enron.

D) The SPE created by Fastow enabled Enron to keep debt off its books while benefiting from transfer and use of the cash borrowed by the SPE.

37)

Which of the following was not a technique used by Enron to manage earnings?

A) used reserves to increase earnings when reported amounts were too low B) deliberately overstated the allowance for uncollectibles and adjusted it downward in future years C) used mark-to-market estimates to inflate earnings in violation of GAAP D) selected which operating assets to "sell" to the SPEs, affecting the gain on transfer and earnings effect

38)

All of the following are red flags that fraud may exist except A) growth in the market share that seems unbelievable.

B) management growth strategy and emphasis on earnings.

C) frequent acquisitions of businesses.

D) reliance on core business as primary income source.

39)

Which of the following is a red flag that fraud may exist?

A) small incremental growth in market share B) low turnover in top management C) one-time sources of income D) consistent external auditors

40)

In the Dichev et al. survey of CFOs, what was a leading indicator of quality earnings?

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A) growth in the market share B) consistent reporting choices over time C) frequent acquisitions of businesses D) reliance on multiple core businesses

41)

Which of the following is not a red flag that fraud may exist?

A) writing off impaired assets B) unexpected increase in accounts receivable C) slowdown of inventory turnover D) change in CFO

42)

Which of the following is not an earnings management technique?

A) failing to write down or write off impaired assets.

B) releasing questionable reserves into income.

C) failing to record expenses and related liabilities when future obligations remain.

D) creating an allowance for uncollectible accounts and adjusting it at year end.

43) Financial shenanigans involving recording revenue too soon include all of the following except A) recording revenue when future services are still to be provided.

B) recording revenue before shipment of a product.

C) recording revenue after customer acceptance.

D) recording revenue when the customer is not obligated to pay.

44) Each of the following is a common revenue recognition device to manage earnings except

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A) multiple deliverables.

B) channel stuffing.

C) buy and hold.

D) round tripping.

45) Oracle settled a lawsuit with Svetlana Blackburn, a high-ranking accountant who claimed she was fired for threatening to blow the whistle on its illegal accounting practices involving A) recording revenue before shipment of a product.

B) improper revenue recognition when the customer was not obligated to pay.

C) recording revenue for acquisitions of businesses.

D) improper revenue recognition for cloud services.

46)

All of the following are methods to inflate cloud revenues except

A) give credit to customers for moving their on-premise license value to the cloud and consider it as booked cloud sales.

B) give a cloud product for free and then extrapolate its sales value to other modules.

C) record revenue for on-premise and cloud figures separately.

D) sell a cloud subscription for a pilot population but book it as if it were for the whole company headcount.

47) Under FASB Accounting Standards Update 2015-05, Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement, fees paid by a customer in a CCA will be within the scope of the internal-use software guidance if which of the following criteria are met?

A) The customer has the contractual right to take possession of the software at any time during the CCA period with a significant penalty.

B) It is feasible for the customer to run the software on its own hardware.

C) The customer is unable to contract with another party to host the software).

D) The company receives a cloud subscription for a pilot population but records it as if it were for the entire company.

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48) Your professor asks you to consider whether earnings management can be justified by arguing that the net benefits of managing earnings exceed any harms that may occur. The professor is asking you to apply what reasoning methods to make the analysis?

A) egoism B) act utilitarianism C) rule utilitarianism D) virtue

49) You work for a company that always pushes the envelope with respect to reporting revenues and expenses. You often disagree with the company because its approach to reporting these amounts cannot be justified from a GAAP perspective. You are upset and are considering whether this is a company that has a culture you want to be part of. Which of the following best characterizes the ethical issues of concern?

A) rights Theory B) moral blindness C) ethical Dissonance D) materiality

50) Debbie and Steve are discussing a lecture given by their ethics professor after class one day. The professor said that misstatements of earnings are always unethical. Debbie agrees with this situation, but Steve does not. What statement might Steve make to best support his point of view?

A) It depends on whether the misstatements were made deliberately.

B) It depends on whether a user relied on the financial statements.

C) It depends on whether the statements lead to a modified or unmodified opinion.

D) All are valid statements for Steve to support his point of view.

51) Kelly and Jordan are writing a term paper together on the concept of "faithful representation" in the financial statements. Kelly is assigned the task of defining it in the context of an amount being an estimate. Which of the following statements should not be used by Kelly in her description?

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A) good faith attempt to gather evidence to support the amount B) clear disclosure of an amount as an estimate C) the nature and limitations of the estimating process D) error free procedures in selecting and applying an appropriate process for developing the estimate

52)

The main accounting issues in the Winners & Losers, Inc case were A) improper bonus accruals and stock-based compensation expenses.

B) capitalization of operating expenses and hidden cash reserves.

C) premature revenue recognition and off-balance-sheet entities.

D) capitalization of operating expenses and off-balance-sheet entities.

53)

Sarah's concern in the Solutions Network case is

A) expenses were delayed at year-end to manage earnings.

B) revenue was recorded at year-end before the agreement with the customer was finalized.

C) revenue was accelerated into an earlier period through channel stuffing.

D) off-balance-sheet entities were not disclosed.

54)

The SEC's complaint in its case against Allergan included a charge that the company A) used off-balance-sheet entities to manipulate earnings.

B) falsified inventory values to inflate earnings.

C) used non-GAAP measures to meet EPS estimates.

D) used EBITDA to obscure reported earnings.

55)

The Blackswan PetFood case deals with

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A) using non-GAAP measures of earnings.

B) acceptability of recording unpaid severance accruals.

C) using EBITDA to obscure earnings.

D) All of these choices are correct.

56)

The accounting shenanigan used in the TierOne case can best be described as A) recording revenue from exclusivity payments too soon or of questionable quality.

B) inadequate accruals for loan loss reserves.

C) shifting future expenses to the current period as a special charge.

D) shifting cloud computing revenues to an earlier period.

57)

The auditors in the Tier One Bank case were investigated by the SEC because it A) failed to obtain sufficient competent evidential matter to support audit conclusions B) failed to exercise the appropriate level of care in its audit C) failed to exercise the proper degree of professional skepticism D) All of these choices are correct.

58)

Which of the following was not an accounting issue in the Sunbeam case?

A) cookie jar reserves B) channel stuffing C) bill and hold sales D) swap transactions

59)

The Monsanto case centered around the A) acceleration of revenue due to channel stuffing arrangements.

B) use of cookie jar reserves to manage earnings.

C) improperly accounting for rebates.

D) use of non-GAAP EPS.

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60) The North Face case deals with materiality and how auditors employ that metric in an audit. The following are all true except A) North Face accounted for barter transactions with full normal margin recognized.

B) Crawford devised the 1997 barter transaction so that it was just beneath the materiality threshold.

C) Crawford followed the GAAP methods that Deloitte suggested.

D) Deloitte proposed an adjusting entry for the 1997 barter transaction, but "passed" on it as immaterial.

61) Which of the following was not one of the schemes used by Beazer Homes to manipulate its earnings?

A) improper recording of revenue on sale-leaseback transactions B) fraudulently increased land inventory expense accounts to reduce earnings C) over-reserving of house cost-to-complete expenses to increase reported earnings in earlier periods D) recording revenue from roundtrip transactions prematurely

ESSAY. Write your answer in the space provided or on a separate sheet of paper.

62) Explain why a company's reported earnings may not necessarily be an objective measure of economic reality. Give examples of when this might occur.

63) Analyze and discuss when earnings management may be an ethical practice and when it is an unethical practice.

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64) Explain the purpose of providing earnings guidance. What are the motivations for making false and misleading disclosures?

65) What is a financial shenanigan and what is it designed to do? Explain each of the financial shenanigans described by Schilit and provide examples of each.

66) Explain what is meant by "quality of earnings" including links to earnings management and audit committee responsibilities in evaluating the quality of earnings?

67)

Categorize the financial shenanigans in the fraud case at Lucent.

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68) The Xerox case deals with accounting for multiple deliverables. Explain what this means in the context of the Xerox fraud.

69) Assume you are a CPA and the accounting manager of a small privately-owned business that has three co-equal shareowners. Your company receives $1,000 from a cash sale of merchandise taken by the customer. Your boss tells you to recognize only $700 and put the other $300 in reserves. What would you do and say and why? Use ethical reasoning to support your position.

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70) In Chapter 6 we discuss the work of Sam Antar, a convicted felon and former CFO of Crazy Eddie, in helping to analyze and ferret out the fraud at Green Mountain Roasters in September 2012. Today Antar works very closely with the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify and catch white collar criminals.

In October 2015, Andy Fastow, also a CFO (at Enron) and convicted felon, spoke at the University of Missouri on "Pride and Repentance: The Enron Story," focusing on his personal shortcomings and similar number-fudging he says is still occurring in companies across the world. Despite the damage he caused, Fastow said he didn't break any rules while at Enron but instead found ways around the rules for his own and the company's benefit.

Do you believe that convicted felons should be allowed to benefit from their work and speeches in a financial or reputational way? Use ethical reasoning to support your answer.

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71) On March 26, 2015, a San Francisco federal judge allowed Zynga Incorporated shareholders to proceed with their class-action lawsuit alleging the online gaming company failed to disclose slumping revenue growth before its market value declined by several billion dollars in 2012. According to the plaintiffs, Zynga concealed declining user activity, masked how changes in a Facebook platform for its games would affect demand, and inflated its 2012 revenue forecast. The shares fell from a peak of $15.91 on March 2, 2012 to below $3 on July 26, 2012, when Zynga posted disappointing earnings and cut its outlook.

Zynga says it recognizes revenue after it determines that a service has been provided to a player and the collection of fees is "reasonably assured." But determining that a service has been provided seems a little more complicated than it would appear, because Zynga needs to differentiate between the types of goods it sells its players.

Zynga, which makes games like FarmVille and Mafia Wars for social networking platforms like Facebook, classifies the game items it sells to players as either "consumable" or "durable" goods.

The former category is for goods that players can immediately use, like energy in the game CityVille; the latter is for goods that players buy and keep for the duration of the game, such as tractors in FarmVille.

The company recognizes revenue for the consumable goods as soon as they are consumed. The durable goods present a problem, however, because things like virtual tractors don't depreciate, but potentially live forever, and the company is obligated to ensure that the virtual game pieces continue to exist in the game world. That's forced Zynga to come up with a system of determining how long that may be.

Discuss the challenges of recognizing revenue for the online products/services Zynga provides to its customers. Draw an analogy between how Zynga should go about recognizing revenue and when gift cards are sold to be used at a later date.

72) Define non-GAAP financial metrics and describe and how these metrics may distort reported earnings.

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Answer Key Test name: Chap 06_6e_ Mintz 1) B 2) D 3) A 4) B 5) A 6) C 7) C 8) C 9) B 10) A 11) C 12) B 13) A 14) D 15) A 16) A 17) C 18) B 19) D 20) B 21) B 22) A 23) C 24) D 25) B 26) C Version 1

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27) C 28) A 29) C 30) B 31) A 32) A 33) C 34) B 35) A 36) A 37) B 38) D 39) C 40) B 41) A 42) D 43) C 44) C 45) D 46) C 47) B 48) B 49) C 50) A 51) A 52) A 53) C 54) C 55) A 56) B Version 1

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57) D 58) D 59) C 60) C 61) D

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62)For one thing, "generally accepted accounting principles" (GAAP) allow an accountant to select from various methods when computing earnings and other financial measures, which could lead to lower quality financial information depending on the accounting methods used. The "quality" of financial information is measured by how well the numbers reflect economic reality. Furthermore, company managers can "manage earnings" subjectively by timing business activities or the reporting of those activities.

Earnings management becomes fraud when companies intentionally provide materially misstated information. W.R. Grace and Company officials, for example, learned this the hard way. The company was charged with stashing earnings in reserve accounts in good years and then tapping them in later years to mask actual slowing earnings.

Without admitting to or denying the charges, Grace later signed a ceaseand-desist order and promised $1 million to support educational programs that enhance public awareness of financial reporting and GAAP. Companies manage earnings when they ask, "How can we best report desired results?" rather than "How can we best report economic reality (the actual results)?" Earnings management includes selecting GAAP methods with concern for appearance rather than reality. It also includes subtle techniques such as changing reported earnings through "performance timing." For example, a manager seeking to reduce expenses in the current period might defer scheduled routine equipment maintenance until the next accounting period. The result is higher reported earnings in the current period, but the maintenance delay may be detrimental to the company's future operations. Also, a company may vary the timing of performance reporting. Recording inventory obsolescence is required under GAAP, for example, but choosing when to record obsolescence is fairly subjective. A manager may know some Version 1

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part of the company's inventory has become obsolete, but if earnings in the current period are lower than desired, he might defer recording the loss, or "write-down," until a future period.

When firms inflate reported financial information by managing earnings, they generate income-increasing accruals that reverse over time. Firms with income-increasing accruals in prior years must, therefore, either deal with the consequences of the accrual reversals or commit fraud to offset the reversals. Prior year income-increasing discretionary accruals might also cause firms to run out of ways to manage earnings. When confronted with earnings reversals and decreased earnings management flexibility, managers might resort to fraudulent activities to achieve objectives that were previously accomplished by managing earnings thereby further impeding the representational faithfulness of recorded amounts and obscuring economic realty.

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63)Earnings management that is motivated by the intent to deceive users of financial statements and the stock markets and/or to enhance one's personal wealth is unethical. It is intent that matters when evaluating the ethics of earnings management.

Earnings management occurs when companies artificially inflate (or deflate) their revenues or profits, or earnings per share (EPS) figures.

Well-publicized ways of managing earnings during the period of financial fraud in the early 2000s were: (1) by using aggressive accounting techniques such as capitalizing costs that should have been expensed (e.g., WorldCom accounted for its line costs as capital expenditures rather than expensing them against revenue); and (2) by establishing or altering the elements of an estimate to achieve a desired goal (e.g., Waste Management's lengthening of the useful lives on trash hauling equipment to slow down depreciation each year).

Another perspective on earnings management is to divide the techniques into two categories: operating earnings management and accounting earnings management. Operating earnings management deals with altering operating decisions to affect cash flows and net income for a period such as easing credit terms to increase sales. Ken Merchant believes while these may appear to be ethical because they involve management choice, the result may be to distort operating policies as is the case when needed repairs are delayed to a subsequent year to make the current earnings look better.

Accounting earnings management deals with using the flexibility in accounting standards to alter earnings numbers. Generally, the end result of earnings management is to distort the application of GAAP, thereby bringing into question the quality of earnings. The question to be answered is whether the distortion is the result of appropriate decision making given that choices exist in the application of GAAP, or if it is motivated by a conscious effort to manipulate earnings for one's Version 1

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advantage, which is fraud.

Examples of earnings management include: ● Meeting or beating analysts' earnings expectations ● Maximizing bonuses and other performance rewards ● Enhancing the value of stock options, and ● Avoiding the consequences of violation of debt covenants A variety of authors believe earnings management is unethical. Healy and Wahlen define it as "when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers."

Dechow and Skinner note the difficulty of operationalizing earnings management based on the reported accounting numbers because they center on managerial intent, which is unobservable. Dechow and Skinner offer their own view that a distinction should be made between making choices in determining earnings that may comprise aggressive, but acceptable, accounting estimates and judgments, as compared to fraudulent accounting practices that are clearly intended to deceive others.

Schipper views earnings management as a purposeful act by management as might be the case when earnings are manipulated to get the stock price up in advance of cashing in stock options.

Hopwood et al. believe that earnings management is management's routine use of nonfraudulent accounting and economic discretion, while earnings manipulation can refer either to the legitimate or aggressive use, or fraudulent abuse, of discretion. By their reckoning, earnings management is legitimate, while earnings manipulation can be legitimate, marginally ethical, unethical, or illegal, depending on its extent. The problem with this distinction is ethics relates to one's intent.

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If one intends to manipulate earnings through smoothing or other techniques, it is unethical because it is designed to deceive another party; if not, why engage in the practice?

Thomas E. McKee defines earnings management as "reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results." McKee believes earnings management reflects a conscious choice by management to smooth earnings over time and it does not include devices designed to "cook the books." McKee contends that a more positive definition is needed that portrays managers' motives in a positive light rather than the negative view adopted by others.

The acceptability of earnings management techniques can be judged using the ethics framework established earlier in the book. Virtue ethics examines the reasons for actions taken by the decision maker as well as the action itself. McKee's definition is self-serving from a management perspective and does not reflect virtues such as honesty (full disclosure) and dependability (reliable numbers). The definition also ignores the rights of shareholders and other stakeholders to receive fair and accurate financial information. McKee's explanation that earnings management is good because it creates a more stable and predictable earnings stream by smoothing net income cannot overcome the fact that a smooth net income by choice does not reflect what investors and creditors need or want to know because it masks true performance. Further, McKee's explanation for the "goodness" of earnings management is nothing more than a rationalization for an unethical act. Hopwood et al. provide cover for their view of the ethics of earnings management by stating that "the ethics issue might possibly be mitigated by clearly disclosing aggressive accounting assumptions in the financial statement disclosures." The problem here is disclosure should not be used to mask the ills of improper accounting that tests the limits of what does and does not Version 1

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present fairly financial position, results of operations, and cash flows. A disclosure may be nothing more than a rationalization for an unethical action with respect to earnings management, thereby closing the Fraud Triangle.

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64)Earnings guidance reflects the comments management makes about what it expects the company will do in the future. Earnings guidance is given by management to provide investors and financial analysts data that indicates expected future earnings, earnings per share, and other items. These comments are known broadly as forward-looking statements. Earnings guidance may be described in a Management Discussion and Analysis (MD&A), operating and financial review, on conference calls with investors and analysts and in press releases available to the public. One concern with earnings guidance statements is that they represent management’s subjective view of the company’s future financial performance, which is exposed to uncertainties and risks. For this reason, the company’s reported information is accompanied by cautions and disclaimers regarding the forward-looking statements to prevent any legal issues.

There are examples of companies that have provided false and misleading information in its public releases. One example is the Cheesecake Factory. On December 4, 2020, the company settled an enforcement action by the SEC that the company had provided misleading COVID-19 related disclosures. This was the first ever enforcement action against a public company for misleading COVID-19 information. The SEC charges centered on alleged misrepresentations the company made in two press releases during the early days of the pandemic regarding how COVID-19 was impacting the company’s business operations and financial condition. Specifically, the SEC determined that the company’s representation that its transition to a togo/delivery restaurant model was enabling the company’s restaurants to “operate sustainably at present” was misleading. In support, the SEC alleged that the statement did not disclose other information contained in internal corporate documents demonstrating that the company was excluding operational expenses from its claim of “sustainability,” was Version 1

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losing approximately $6 million per week, and had rapidly depleting cash reserves.

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65)Financial shenanigans are acts or actions designed to mask or misrepresent the true financial performance or actual financial position of a company or entity. Financial shenanigans can range from relatively minor infractions involving creative interpretation of accounting rules to outright fraud over many years. In almost every instance, the revelation that a company's stellar financial performance has been due to financial shenanigans rather than management successes will have a negative effect on its stock price and future prospects. Depending on the scale and scope of the shenanigans, the repercussions can range from a steep selloff in the stock to the company's bankruptcy and dissolution.

Financial shenanigans can be broadly classified into two types: a. Schemes that overstate revenues and profits. Artificially boosting earnings per share (EPS) and growth rates has a direct and positive impact on a company's valuation, which generally rewards management through higher compensation and profits on stock options. b. Schemes that understate revenues and profits—this is typically done to smooth out net income over time periods and make it appear less volatile. These shenanigans, while undesirable, are less serious than those that overstate revenues and profits.

Companies have numerous avenues to engage in financial shenanigans if they so desire. These include recognizing revenues prematurely, recording sales made to an affiliate or recording sales of unshipped items, capitalizing rather than expensing research and development costs, reclassifying balance sheet items to create income, amortizing costs or depreciating assets at a slower pace, setting up special-purpose vehicles to hide debt or mask ownership, and so on. In most instances of far-reaching and complex fraud, financial shenanigans were not detected in the period of financial frauds in the early 2000s.

Schilit has distilled the most common tricks into seven categories. At the very least, he says, these maneuvers should set off alarm bells.

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Shenanigan No. 1: Recording Revenue Too Soon or of Questionable Quality a) Recording revenue when future services remain to be provided b) Recording revenue before shipment or customer's unconditional acceptance c) Recording revenue although customer is not obligated to pay d) Selling to an affiliated party e) Giving customer something of value as a quid pro quo f) "Grossing-up" revenue Shenanigan No. 2: Recording Bogus Revenue a) Recording sales lacking economic substance—side agreements b) Recording as revenue cash received from lender c) Recording as revenue investment income d) Recording as revenue supplier rebates tied to future required purchases e) Release revenue improperly "held back" before a merger Shenanigan No. 3: Boosting Income with One-Time Gains a) Recording gains selling assets recorded at deflated book value b) Including investment income or gains as revenue c) Including investment income as reduction in operating expenses d) Creating income by reclassification of investment gains Shenanigan No. 4: Shifting Current Expenses to a Later or Earlier Period a) Capitalizing normal operating costs, particularly if recently changed from expensing b) Changing accounting policies and shifting current expenses to an earlier period c) Amortizing costs too slowly d) Failing to write-down or write-off impaired assets e) Releasing asset reserves into income Version 1

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Shenanigan No. 5: Failing To Record (or Improperly Decreasing) Liabilities a) Failing to record expenses (and related liabilities) when future obligations remain b) Reducing liabilities by changing accounting assumptions c) Releasing questionable liability reserves into income d) Creating sham rebates e) Recording revenue when cash is received, yet future obligations remain Shenanigan No. 6: Shifting Current Revenue to a Later Period a) Creating reserves and releasing them into income in a later period b) Improperly holding back revenue just before an acquisition closes Shenanigan No. 7: Shifting Future Expenses to the Current Period (as a One-Time Charge) a) Improperly inflating amount included in special charge b) Improperly writing off in-process R&D costs from acquisition c) Accelerating discretionary expenses into the current period An indicator of financial shenanigans is a sudden change in accounting practices. Such shifts may be ploys to cover a deteriorating core business. Another sign is when companies have a dramatic fluctuation in key indicators such as cash flow, accounts receivable, or assets.

Accounting classifications that are used may provide red flags that a shenanigan exists, such as "prepaid expenses and other current assets," "noncash revenue," or "unbilled receivables." Meanwhile, large writeoffs can be legitimate reflections of a plant closure—or an excuse to lower the value of assets so future performance looks even better.

Hidden reserves (cookie-jar reserves) can also indicate an attempt to smooth net income over time.

In short, investors should be suspicious of anything that has the potential to hide a company's true earnings picture. That means questioning accounting shifts that stem from so-called "changes in strategy," as well Version 1

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as understanding what makes up the different categories on a company's financial statement.

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66)The terms "quality of earnings" and "earnings quality" have no single, agreed-upon meaning. Both terms are used when making accounting choices; considering the business cycle, including timing of transactions; and discussing earnings management. Some use "quality of earnings" to mean the degree to which management's choices of accounting estimates can affect reported income (these choices occur every period). For example: those who use the term in this manner judge an insurance company's earnings to be of low quality. The company's management must re-estimate its future payments to the insured, by period—and the estimates are made about long-term considerations, such as how long a person will live or future earnings on investments.

Such estimates are difficult to quantify at best, which gives the company the opportunity to report a wide range of periodic earnings. Thus, even if management does not use questionable estimates to manipulate its earnings, the opportunity is there—which causes users to think earnings numbers are of low quality.

Others use the phrase to mean the degree to which management takes advantage of its flexibility. For them, an insurance company that does not vary its methods and estimating techniques, despite the opportunity to do so, has high-quality earnings.

Some have in mind the proximity in time between revenue recognition and cash collection on the one hand, and expense recognition and cash expenditure on the other. For them, the shorter the delay, the higher the quality. A company with all cash sales, no warranty or other aftermarket promises, and no long-term assets has high-quality earnings. A company engaged in a long-term construction project with cash collections near project's end, and construction equipment with long depreciable lives, has low-quality earnings.

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items that result in income recognition that's more likely to lead to recurring patterns of income. For them, the more likely an item of earnings is to recur, the higher its quality will be. Consider, for example, an equipment dealer who leases expensive and complex machinery and equipment to customers. The leasing dealer who uses operating lease accounting has perfectly matched revenue recognition and cash collection, but the recurring nature of the revenue, with monthly receipts, might mislead the unwary reader of financial statements into thinking that the key, income-generating transaction—the signing of the lease—recurs.

The SEC has long recognized that accrual accounting requires important estimates and, since 2003, has required companies to list the critical accounting judgments and estimates that underlie its financial reporting.

The wider the range of reasonable estimates, the more management's choice will influence bottom-line net income and comprehensive income.

Management's ability to choose a number from a reasonable range and be confident no one can say some other number is better gives them the opportunity to manage earnings. When management's number-choice is made with an eye to its effect on net or comprehensive income, it is engaging in "earnings management."

Audit committee members must be aware of the ways in which management's accounting-related choices provide opportunities to manage earnings—through timing of transactions and making estimates.

The company's summary of critical accounting policies and estimates, required by the SEC, provides a checklist to guide thinking. Audit committee members can use the summary of critical accounting policies to understand the nature and scope of transactions that require management to make the judgment or estimate.

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67)Lucent's financial shenanigans involved almost all categories identified by Schilit to manipulate recorded revenue.

Technique

Description

Shenanigan Number

Recorded revenue too Lucent restated year 2000 earnings, removing $679 million of improperly soon included revenue.

No. 1

Boosted income with During fiscal 1998, Lucent recorded one-time gains $558 million of pension income—over 50% of earnings for the year.

No. 3

No. 4 Failed to write down Lucent reduced the allowance for impaired assets doubtful accounts and released the previous reserves despite an increase in receivables of 32%.

No. 4 Shifted current Lucent reduced the allowance for expenses to a later inventory obsolescence although the period inventory balance increased.

Reduced liabilities Lucent modified its accounting by changing approach and assumptions for accounting pensions. assumptions

No. 5

Released reserves into income

No. 5

Lucent released $100 million of a previously recorded restructuring reserve, boosting operating income.

Created new reserves Lucent wrote off $2.4 billion (58% of No. 7 from 10 acquisitions the cumulative purchase price) as an in-process R&D. This new reserve could be released into earnings later.

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68)The challenge of transactions with multiple deliverables is to decide whether each element should be separated out and recognized as revenue immediately at the point of sale or whether one or more elements can stand-alone and be recognized over the life of the agreement.

Xerox sold copiers and other office equipment to its customers for cash, but it more frequently entered into long-term lease agreements in which customers paid a single negotiated monthly fee in return for the equipment, service, supplies, and financing. Xerox referred to these arrangements as "bundled leases." These transactions created revenue recognition issues because of the "multiple deliverables."

The leases met the criteria under SFAS 13 to be accounted for as "salestype" leases, whereby the fair value of the equipment leased would be recognized as income in the period the lease is delivered, less any residual value the equipment was expected to retain once the lease expired. GAAP permits the financing revenue portion of the lease to be recognized only as it is earned over the life of the lease. SFAS 13 also specifies that the portion of the lease payments that represents the fee for repair services and copier supplies be prorated over the term of the lease, matching it against the financing income. These are the multiple deliverables.

As competition grew for Xerox in the 1990s the company encountered challenges to continue reporting earnings. The management told KPMG that it was no longer able to reasonably assign a fair value to the equipment as it had in the past. The company abandoned the value determinations made at the lease inception, for public financial reporting purposes, but not for internal operating purposes, and substituted a formula that management could manipulate at will. Xerox did not test the value determinations to assess the reliability of the original method or if the new method did a better job of accurately reflecting the fair value of copier equipment.

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Xerox's "topside" lease accounting devices consistently increased the amount of lease revenues that Xerox recognized at the inception of the lease and reduced the amount it recognized over the life of the lease.

One method was called return on equity (ROE), which pulled forward a portion of finance income and recognized it immediately as equipment revenue. The second, called margin normalization, pulled forward a portion of service income and recognized it immediately as equipment revenue. These income acceleration methods did not comply with GAAP because there was no matching of revenue with the period during which: (1) financing was provided, (2) copier supplies were provided, and (3) repairs were made to the leased equipment.

Extended Discussion (This is a good research question).

FASB's Accounting Standards Update (ASU) 2009-13 requires a vendor to evaluate all deliverables in an arrangement to determine whether they represent separate units of accounting. This evaluation must be performed at the inception of an arrangement and as each item in the arrangement is delivered. ASU 2009-13 retains from Issue 00-21 two of the three criteria for when delivered items in a multiple-deliverable arrangement should be considered separate units of accounting and states (codified in ASC 605-25-25-3): In an arrangement with multiple deliverables, the delivered item or items are considered to be a separate unit of accounting when both of the following criteria are met: (a) The delivered item or items have value to the customer on a standalone basis. The item or items have value on a standalone basis if they are sold separately by any vendor or the customer could resell the delivered item(s) on a standalone basis. In the context of a customer's ability to resell the delivered item(s), this criterion does not require the existence of an observable market for the deliverable(s). (b) If the arrangement includes a general right of return relative to the Version 1

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delivered item, delivery or performance of the undelivered item or items is considered probable and substantially in the control of the vendor.

Example: Entity A, a manufacturer of highly specialized electronic equipment, enters into a $3 million arrangement to deliver this equipment and provide implementation services after the delivery. The effort "A" must expend to perform the implementation services can vary significantly from customer to customer. Thus, "A" cannot reliably estimate the amount of time it needs to perform the implementation services for any particular customer. Entity A therefore determines that it does not have objective and reliable evidence of fair value for the implementation services. The electronic equipment has stand-alone value to the customer, and the agreement has no general right of return.

Evaluation Under Issue 00-21 Because A does not have objective and reliable evidence of fair value for the implementation services, the electronic equipment and implementation services are one unit of accounting. Entity A determines that an appropriate method of revenue recognition for its single unit of accounting is to recognize the $3 million fee as implementation services are provided.

The separation criteria for the electronic equipment are met because the equipment has stand-alone value to the customer and no general right of return exists. Therefore, both the electronic equipment and the implementation services deliverables are accounted for as separate units of accounting and "A" must determine the selling price for each deliverable and allocate a portion of the fee to each deliverable.

Entity A determines that an appropriate method of revenue recognition is to recognize the portion of the fee allocated to the electronic equipment upon its delivery and the remaining portion of the fee as implementation services are provided.

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69)Your boss is telling you to establish a cookie-jar-reserve by separating out $300 of the $1,000 that should be recorded as revenue now. It could be that the company is doing extremely well in the current period and your boss wants to have a cushion for future downturns in earnings. The accounting you are being told to do is both illegal (fraud) and unethical. Since the customer took the merchandise and paid cash there is no basis to defer recording the revenue other than to smooth net income over time through the cookie-jar, earnings management technique.

As a CPA, I cannot go along with my boss. I need to act with integrity and first try to convince her of the wrongness of her position. If that doesn't work, then I need to follow the prescribed rules for when differences of opinion on GAAP matters exist and go to the superior of my boss all the way up to the CEO and, if necessary, audit committee/board of directors. If the difference still exists, I must consider any further ethical obligations. (see Exhibit 3.13).

Since the company is not publicly owned, whistleblowing under the Sarbanes-Oxley Act and the Dodd-Frank Financial Reform Act are not options. However, the state government probably has a whistleblowing process to follow.

If the company has an internal audit department, it would be wise to inform them of what has transpired. The internal auditors have some leverage that can be used with management by virtue of their reporting responsibilities with the audit committee/board of directors. I can also consider informing the outside auditors assuming there is an external audit.

In no uncertain terms can I stand idly by while earnings are being managed in a deliberate, deceitful manner. Not only are the results of operations distorted in the current and future periods, but if I go along I will be part of the cover-up. From an ethical perspective I have to ask Version 1

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myself: What happens if disclosure of my role becomes known at a later date? The ramifications are very serious as I become part of the problem and not the solution.

A universal perspective would guide me to do what I would want other accountants to do in similar situations for similar reasons. As a person of conscience, I must speak up and do what I can to correct the improper accounting.

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70)Antar conducted detailed financial analysis that was instrumental in identifying the red flags that fraud existed at Green Mountain Roasters.

From a utilitarian perspective, the benefits to the public and shareowners of having someone with his obvious skills perhaps pointing out in advance that fraud may exist is immeasurable. It could save millions in lost shareholder value and, possibly, protect jobs. The downside is a convicted felon is given instant credibility and his crimes soon become forgotten. Many were harmed by what he did and allowed to occur, and in all likelihood, they are not too thrilled in seeing Antar "profit" from his actions.

Did Antar act out of true remorse or because he is trying to rebuild his reputation? He seems sincere as indicated by a disclosure he made at the end of his blog: "I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped my cousin Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes in cold-blood for fun and profit, and simply because I could. If it weren't for the heroic efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff's lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today.

There is a saying, "It takes one to know one. 'Today, I work very closely with the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify and catch whitecollar criminals. Often, I refer cases to them as an independent whistleblower. I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities. More recently, I've helped the AICPA Fraud Task Force develop better methods for detecting fraud. I do not want or seek forgiveness for my vicious crimes from my victims. My past sins are Version 1

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unforgivable."

Antar writes opinion pieces about white collar fraud at: http://whitecollarfraud.com/white-collar-crime/a-convicted-felons-viewof-white-collar-crime/.

As for Fastow, he spent only five years in prison for his role as the mastermind of the fraud at Enron and was released in December 2011.

At this stage after his release it is difficult to say whether he is reformed, as appears to be the case with Antar, or just speaking as a way of regaining some modicum of a reputation. It does not seem that he is truly reformed because of his statement that he "didn't break any rules while at Enron but instead found ways around the rules for his own and the company's benefit." In other words, he dodged the truth by finding ways to financially engineer the special-purpose transactions that was the crux of the fraud at Enron. He knowingly created entities that lacked economic substance so that the critical characteristic in recording financial information—representational faithfulness—was not met.

Moreover, he served as the CFO of Enron at the same time he was the managing partner of some SPEs, thereby creating an obvious conflict of interest that violated the company's ethics code.

At this point Fastow seems motivated by egoism and still has not come to grips with his role in the Enron fraud and taken responsibility for his criminal actions. He seems to be playing the ethical legalism game in his statement.

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71)The issue is whether revenue should be recognized immediately and based on what indicators or if the revenue should be deferred, which creates a problem of determining how to recognize future revenues. The latter requires estimates of usage that are challenging at best because of the pattern of usage especially with the durable goods.

Basically it has to do with the accounting concept of "delivery" of a product or service. A virtual good is taken to be a service that, if not immediately consumed, is not "delivered" until it can reasonably assumed to no longer be in use. But delivery is not so easy to determine in the virtual world.

One approach is for Zynga to recognize virtual currency (e.g., Farmville cash) as revenue when players spend it. This would be very similar to prepaid gift cards. So although they can book the cash, until the balance of virtual currency is actually spent Zynga can't recognize it in their balance sheet. The unrecognized revenue shows up in the balance sheet as a deferred liability because Zynga has future service obligations.

The gift card analogy would work as follows: You go to your favorite department store and buy a gift card. They collect your $100 and hand you a card. That transaction is recorded as a liability to the company, in the same general area deferred revenues are recorded on the balance sheet. The merchant cannot record it as revenue because they really haven't given anything of value in return for your $100, just a piece of plastic. In short, it is clearly a liability to perform future services, not a sale, which occurs when the recipient of the gift card goes into the retailer and uses it to buy merchandise.

Now, you give that gift certificate you just bought to your spouse for her birthday. She goes to the store and buys herself that new dress she's been eyeing for a while, handing the sales clerk the gift card as payment. It is at that point the "sale" is recorded. The net effect of these two transactions is that 1) the company receives $100 and 2) has provided Version 1

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value (the dress) in exchange.

Extended Discussion (This is a good research question).

This example coincides loosely how Zynga describes revenue recognition in their S-1. "We recognize revenue when all of the following conditions are satisfied: (1) there is persuasive evidence of an arrangement; (2) the service has been provided to the player; (3) the collection of our fees is reasonably assured; and (4) the amount of fees to be paid by the customer is fixed or determinable.

When you play a Zynga game, you've paid real money for virtual money, which you can think of as a fake online bank account of sorts.

This is equivalent to the gift card mentioned above. In the game world, instead of buying a real dress, the player buys a "virtual dress," paying for that virtual dress with virtual money. It is at that point where the virtual money (i.e. gift card) no longer exists and the "service" (if you can call it that) has been rendered. That is the point where Zynga is taking their deferred revenue into income.

The proceeds from the sale of virtual goods are initially recorded in deferred revenue. Zynga categorizes its virtual goods as either consumable or durable. Consumable virtual goods, such as energy in CityVille, represent goods that can be consumed by a specific player action. For the sale of consumable virtual goods, the company recognize revenues as the goods are consumed. Durable virtual goods, such as tractors in FarmVille, represent virtual goods that are accessible to the player over an extended period of time. Zynga recognizes revenue from the sale of durable virtual goods ratably over the estimated average playing period of paying players for the applicable game, which represents the best estimate of the average life of durable virtual goods.

The company says in its S1 filing with the SEC that it recognizes revenue from the sale of durable virtual goods ratably, based on an estimate of the average playing time of paying players for any given Version 1

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game. That estimate is a proxy for the estimate of the average life of the durable virtual goods.

But, because the goods are virtual, that measure in itself isn't consistent.

From the S1: "For the three months ended March 31, 2011, the estimated average playing period of paying players for our games ranged from ten to 25 months. Future paying player usage patterns and behavior may differ from the historical usage patterns and therefore the estimated average playing periods may change in the future."

That in itself poses a risk to the company's revenue.

Future usage patterns may differ from historical usage patterns and therefore the estimated average playing periods may change in the future. Zynga assesses the estimated average playing period for paying players and the estimated average life of their virtual goods quarterly.

The company assumes that there will be changes in the mix of virtual goods sold due to new game introductions, reduced virtual good sales in existing games or other factors, including changes in estimates in virtual good life or their ability to make such estimates. When such changes occur, and in particular if more of their revenue in any period is derived from goods for which revenue is recognized over the estimated average playing period, or that period increases on average, the amount of revenue that it recognizes in a future period may be reduced from prior periods, perhaps significantly.

Zynga says it has only been able to make a distinction between consumable and durable goods since 2009. That's a relatively short timeframe and one during which it experienced incredible growth, so it's not only working with a limited sample, but one that has likely changed massively. Add in the difficulty in forecasting future online gaming habits and it's reasonable to wonder how much some of these estimates could be adjusted in the not-too-distant future.

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72)Most companies disclose non-GAAP financial metrics; however, little is known about the objectives of disclosing these numbers, how they are determined, management’s intent in disclosing non-GAAP amounts, regulation of these disclosures, and the auditors’ responsibilities. This is important because adjusting earnings from GAAP to a non-GAAP measure is subject to earnings management and it can mislead investors.

SEC Regulation G and Item 10(e) of Regulation S-K define a “nonGAAP financial measure” as a numerical measure of historical or future financial performance, financial position, or cash flows, that excludes amounts that are included in the most directly comparable measure calculated and presented in accordance with GAAP or includes amounts that are excluded from the most directly comparable measure so calculated and presented.

The SEC regulations define a non-GAAP financial measure as intended to capture all measures that have the effect of depicting either a measure of performance that is different from that presented in the financial statements (such as income or loss before taxes, or net income or loss as calculated in accordance with GAAP) or a measure of liquidity that is different from cash flow or cash flow from operations computed in accordance with GAAP. An Audit Analytics study found the top five non-GAAP metrics were: adjusted operating income, earnings-per-share (EPS), cash flow, EBITDA, and funds from operations. Former SEC Chair Mary Jo White, expressed her concern that “[i]n too many cases, the non-GAAP information, which is designed to supplement the GAAP information, has become the key message to investors, crowding out and effectively supplanting the GAAP presentation.” Beyond that, the diverse items that have been used by companies to adjust GAAP net income to non-GAAP adjusted net income raises questions about the consistency and Version 1

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comparability of non-GAAP amounts. Some companies present EPS on a non-GAAP basis adding another complexity to the understandability issue.

It is possible that management may use non-GAAP reporting because they are unable to produce GAAP earnings that meet or beat earnings targets or expectations—even after engaging in earnings management. It may be difficult for an auditor to make this determination without understanding management’s motivation in disclosing non-GAAP amounts and in selecting one type of non-GAAP measure versus another. External auditors need to assess motivation, look for pressures on management to disclose earnings numbers that make the company look like the company is doing better than it really is, and be aware of other factors that might incentivize management to find alternative ways to present operating performance that also portray them in the most positive light. The SEC has brought enforcement actions against companies that do not portray GAAP earnings as prominently as nonGAAP earnings.

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Chapter 7: Consequences of Earnings Management: The Need for Ethical Leadership in Accounting MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

1) It can be said that ethical leaders exhibit each of the following traits except for A) ethical leaders understand the need for respect, openness, and trust.

B) ethical leaders aim to empower others to achieve success based on right action.

C) ethical leaders take responsibility for their actions and are accountable.

D) ethical leaders encourage behaviors whereby employees do what the leaders say.

2)

The statement about leadership attributed to Ciulla is

A) visions are not simple goals, but rather ways of seeing the future that implicitly or explicitly entail some notion of the good.

B) principle-centered leaders build greater, more trusting, and communicative relationships with others in the workplace.

C) leaders lead by example not based on what they say.

D) leaders always follow the law even if it deviates from ethical action.

3)

With respect to leadership in the accounting profession, it might be said that

A) ethical judgment is more important than how one makes decisions B) partners must exhibit moral imagination through ethical perception of what it means to be ethical, professional, and successful C) partners must exhibit ethical decision making through ethical sensitivity to the needs of one's firm D) how one makes decisions is more important than ethical leadership

4)

Trevino et al. believe ethical leaders possess each of the following two traits A) moral follower and moral servant.

B) moral person and moral manager.

C) moral person and moral employee.

D) moral person and transformational leader.

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5)

To be an ethical leader, executives must also: A) Attend to cultivating ethics and be an ethical person.

B) Attend to client's interest and be a moral person.

C) Serve in followership roles.

D) Serve as servant leaders.

6)

To hold employees accountable to ethical standards, moral managers A) walk the talk of leadership B) use reward systems to encourage ethical performance C) strive to do what is right regardless of the consequences of one's actions D) All of these choices are correct.

7)

In accounting, building a reputation for ethical leadership means to

A) enable ethics and values to take place without fear of retaliation.

B) enable ethics and values to shine through the fog of beating the competition and meeting financial projections.

C) refrain from using non-GAAP measures of earnings.

D) create an environment that fosters short-term shareholder value.

8)

An authentic leader

A) is focused on building long-term shareholder value, not in just beating quarterly estimates.

B) is focused on controlling management's desires to beat quarterly estimates.

C) empowers employees to make choices after discussing them with leaders.

D) acts consistently with norms of behavior.

9)

Transformational leaders

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A) empower employees to act based on their ethical goals and values.

B) follow what top management sets as its goals for the organization.

C) cause change in individuals and social systems.

D) connect the follower's behavior to the collective identity of the organization.

10)

It can be said about followership that A) followership is the same as leadership.

B) followership and servant leadership are the same.

C) followership is the flip side of leadership.

D) followers are always transformational leaders.

11)

Servant leaders

A) advocate a perspective that leaders have a responsibility to serve their followers by helping them to achieve followers' goals.

B) servant leadership is the flip side of authentic leadership.

C) promote a culture that enhances organizational outcomes.

D) help followers to fulfill their needs by modeling ethical values, attitudes, and behaviors.

12) Which common characteristic is shared by the concepts of followership, servant leaders, and authenticity?

A) values-based leadership B) sensitivity to ethical dilemmas C) adherence to organizational norms even if it means compromising one's values D) leader ethicality

13)

De Cremer and Tenbrunsel characterize ethical leadership in part as

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A) intention to demonstrate normatively appropriate conduct.

B) environment that promotes transformational leadership.

C) influencing followers to always adhere to leaders' goals for the organization.

D) environment that promotes servant leadership.

14)

Social Learning Theory holds that

A) employees learn what to do by observing their leaders' behavior and its consequences B) employees learn what not to do by observing their leaders' behavior and its consequences C) employees learn what to do and what not to do by observing their leaders' behavior and its consequences D) employees learn what to do and what not to do when antisocial behaviors exist

15)

Leaders who engage in unethical behaviors create a context supporting A) cognitive dissonance.

B) parallel deviance.

C) moral intensity.

D) leader perseverance.

16)

A good example of antisocial behavior is A) Dennis Kozlowski's use of corporate resources for personal purposes.

B) Betty Vinson's decisions to go along with financial wrongdoing.

C) Jeff Skilling's policy of "rank and yank".

D) Whistleblowing by Cynthia Cooper.

17)

The more intense the ethical issues, the more likely

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A) decision makers will act in accordance with their own ethical values B) decision makers are aware of the ethical implications of their intended actions C) organizations will foster ethical behavior D) organizations will establish an ethical tone at the top

18)

Each of the following is a factor that needs to be evaluated for moral intensity except A) magnitude of consequences of the moral act.

B) degree of social consensus that the moral act is unethical.

C) feelings of proximity of the moral agent to the moral act.

D) All of these choices are relevant factors.

19)

An important factor in evaluating moral intensity is A) temporal immediacy of the effect of the moral act.

B) consequences of proximity of the moral agent and ethical leadership.

C) influence of moral judgment on moral intensity.

D) All of these choices are relevant factors.

20) Taylor and Curtis found from their study of whistleblowing among public accounting seniors that A) moral intensity affects the intention to report wrongdoing.

B) moral intensity is independent of the intention to report wrongdoing.

C) ethical leaders ignore the magnitude of consequences when deciding whether to blow the whistle.

D) ethical leaders base their decision whether to blow the whistle on temporal immediacy of the effect of the moral act.

21)

An essential element in creating an ethical environment in an audit firm is

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A) socialization of employees B) moral intensity of the situation C) responsible leadership of the firm D) firm values, behavior, and attitudes

22)

The ethical environment within an accounting firm is created through adherence to the A) AICPA Code of Professional Conduct.

B) rules and regulations of the SEC. C) stated values and management practices.

D) moral intensity and management practices.

23)

Ponemon hypothesized that there is a correlation between A) moral intensity and subordinates' personal characteristics and decision-making styles.

B) organizational culture and subordinates' personal characteristics and decision-making

styles.

C) culture of the organization and leadership style.

D) leadership style and followership.

24)

Organizational dissidence in audit firms is created when A) client interests are placed ahead of the public interest.

B) firm interests are placed ahead of the public interest.

C) individual values do not fit into expectations of the firm.

D) individual values lead to firms changing their values to achieve greater socialization.

25)

Selection-socialization bias in audit firms pertains to

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A) whether a firm hires and promotes individuals who fit into the prevailing firm culture and whether individuals unable to fit leave.

B) whether a firm fires individuals who do not fit into the prevailing firm culture.

C) whether individuals choose to work for a particular firm.

D) effective leadership and followership.

26) The results of Morris's study of the influence of authentic leadership and ethical firm culture on auditor behavior is A) a significant positive correlation exists between authentic leadership and dysfunctional audit behaviors.

B) a significant negative correlation exists between authentic leadership and dysfunctional audit behaviors.

C) audit seniors more frequently prematurely sign off on audit work than under-report time.

D) audit seniors act on their own values regardless of their perceptions of the firm culture.

27) In Bobek's study of the effect of gender on decision making of public accounting professionals, it was found that A) males were more likely than females to concede to the client's demands in an audit condition.

B) males were less likely than females to concede to the client's demand in an audit condition.

C) males were more likely than females to use an intuitionist approach in decision making.

D) males were less likely to concede to the client's demands on a tax condition than an audit condition.

28) Which of the following is not an attribute of internal audit leadership according to Chambers?

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A) honesty B) objectivity C) accountability D) trustworthiness

29)

Accountants may hesitate to record a questionable entry if they know

A) internal audit is likely to detect the possible error.

B) internal audit is likely to detect the inappropriate financial reporting practices.

C) internal audit is likely to communicate it to the external auditors.

D) internal audit is likely to blow the whistle on inappropriate financial reporting practices.

30) Arel et al. in their study of ethical leadership, the internal audit function, and moral intensity on a decision to record a questionable entry found that A) there is a joint influence of ethical leadership and internal audit quality on accountants' willingness to book a questionable entry.

B) there is a joint influence of internal audit quality and tone at the top on accountants' willingness to book a questionable entry.

C) ethical leadership does not influence accountants' willingness to book a questionable entry.

D) internal audit quality does not influence accountants' willingness to book a questionable entry.

31) Bobek et al. found a disconnect between tax partners and nonpartner tax practitioners with respect to

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A) perceptions of ethical leadership when they described a self-identified ethical dilemma.

B) perceptions of ethical leadership when there was a difference of opinion on a tax matter.

C) perceptions of organizational ethics when they described a self-identified ethical dilemma.

D) perceptions of organizational ethics when there was a difference of opinion on a tax matter.

32) Bobek et al. found that nonpartners are more likely to perceive the ethical environment of their firm as strong when they A) believe they have a meaningful role in shaping and maintaining the ethical environment of their firms.

B) believe ethical leaders consider their interests in firm decision making.

C) are included in firm decision making.

D) have a high frequency of receiving mentoring.

33)

The fraud at HealthSouth at the structural level of the company was more intense because A) the external auditors went along with the fraud.

B) the board of directors managed the fraud.

C) checks and balances were eliminated and organizational culture was compromised.

D) there was no hotline to report financial fraud.

34)

Ethical leadership failure can be caused by A) lines of communication are blurred.

B) ignoring ethical boundaries within a company.

C) organizational factors promote unethical action.

D) All of these choices are correct.

35)

The ethical failures in the leaders at Andersen were caused by

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A) volitional and cognitive rationalizations.

B) violations of social contracts with shareholders, investors, and the public.

C) deficiencies in internal controls.

D) considering the interests of parties outside their group of followers.

36) According to Mesmer-Magnus and Viswesvaran, organizational employees have three options to address an unsatisfactory situation faced within an organization. These include A) exit the organization, voice discontent, discuss matters with the board of directors.

B) exit the organization, remain silent, report the matter to the external auditors.

C) exit the organization, remain silent, voice discontent.

D) exit the organization, blow the whistle, report the matter to the authorities.

37) Taylor and Curtis studied the complex relationships in accounting firms that influence an individual's decision to report an ethical violation and found at the center of these potentially conflicting layers of commitment lies A) auditor perceived professional identity.

B) ethical leadership.

C) seriousness of the violation.

D) the ethical violation itself and the individual's personal reaction to it.

38) In Brennan and Kelly's study of the factors that influence propensity or willingness to blow the whistle among audit trainees, the authors identified each of the following factors except A) audit firm organizational structures.

B) audit firm ethical leadership.

C) personal characteristics of whistleblowers.

D) situational variables.

39)

Leadership in accounting is different than leadership in most other organizations because

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A) accountants are regulated by state board of accountancy.

B) accountants are expected to place the public interest above all else.

C) accountants are obligated to follow a strict code of ethics.

D) accountants are answerable to firm management, not their clients.

40)

A unique aspect of the story of ethical leadership illustrated by Diem-Thi Le is that A) Le's working papers were altered by her supervisor.

B) Le's audit opinion was changed from modified to unmodified.

C) Le's whistleblowing complaint did not lead to retaliation.

D) Le was fired from her job.

41)

Values-based leadership can best be summed up as A) clearly articulating a vision for the organization.

B) defining organizational values and work culture.

C) clearly articulating and demonstrating one's values.

D) using the Giving Voice to Values methodology to create a culture of compliance.

42) The Giving Voice to Values framework distinguishes between organizational and individual values because A) organizational values are internal to each individual while individual values are highly visible within the organization.

B) organizational values are highly visible within the organization while individual values are internal to the very core of individuals.

C) organizational values are influenced by ethical leadership while individual values are influenced by perceptions of organizational values.

D) organizational values create perceptions of ethical leadership while individual values are innate to the individual.

43)

Ethical leadership competence refers to

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A) leaders ability to deal with moral problems in an autonomous way.

B) leaders ability to deal with moral problems in an automatic way.

C) leaders ability to set the tone of the organization as an ethical one.

D) leaders ability to develop problem-solving and decision-making skills.

44) The Ethical Leadership Scale developed by Kelly and Early identifies each of the following measures of leadership A) personal ethical competence, ethical leadership, and ethical standards.

B) personal ethical competence, ethical standards, and ethical organization.

C) personal ethical competence, ethical leadership, and ethical organization.

D) ethical leadership, moral intensity, and ethical culture.

45)

The ethical dilemma in the Monsanto Company Roundup case can best be summed up as

A) whether an auditor is allowed to share information about a client with a nonaudit member of the firm.

B) proper accounting for rebates offered to distributors and retailers.

C) whether an audit firm may recommend their own ERP software package to an audit client.

D) whether non-GAAP accounting disclosures and presentation should be used.

46) With respect to ethical leadership, the issue in the General Electric case can best be characterized as A) the relationship between the chief internal auditor and CEO. B) the leadership style of the executives and culture of the company.

C) the leadership style of the chief internal auditor and tone at the top.

D) the relationship between an audit client and management advisory services client.

47)

On an organizational level, the key issue in the Healthsouth case is

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A) the influence of moral intensity on ethical decision making.

B) the influence of ethical leadership on accounting and auditing.

C) the role of ethical leadership and corporate governance in the accounting fraud.

D) the role of professional skepticism and moral intensity in corporate governance and accounting fraud.

48)

The KPMG tax shelter case deals with A) the culture of the tax practice and aggressive marketing of tax shelters to wealthy

clients.

B) the influence of independence and objectivity in selling tax shelter products to audit clients.

C) the use of a realistic possibility of success opinion letter on tax shelters for clients.

D) the aggressiveness of tax clients in demanding the firm provide opinion letters on tax shelter products.

49)

The leadership style of management at Krispy Kreme can best be summed up as A) aggressively sought to manage earnings using round-trip transactions.

B) pressured auditors to overlook material misstatements in the financial statements.

C) encouraged employees to engage in deception and fraud through franchisees.

D) All of these choices are correct.

50)

One of the key questions raised by the facts of the Friars For Life case is A) should the client be allowed to determine what appears in the financial statements?

B) should audit firms develop tax shelter arrangements for wealthy clients?

C) should audit firms discuss their audit opinions with clients?

D) should the client be able to record revenues from future scheduled transactions?

51) by

In the Hertz fraud, the company tried to explain its use of non-GAAP financial measures

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A) comparing them to aggressive but ethical measurements.

B) comparing the validity of the amounts to pre-tax GAAP income.

C) having a conference call with financial analysts to explain their position.

D) correcting problems in internal controls.

52)

The SEC requires stealth restatements to be A) disclosed only in periodic reports.

B) disclosed only in an 8-K report or amended 10-K/A or 10-Q/A. C) increased to more 50% of restatements.

D) disclosed in ten business days after determination of need for restatement.

53)

The best definition of a financial restatement is

A) a company, either voluntarily or under prompting by its auditors or regulators, revises its public financial information that was previously reported.

B) a company, either voluntarily or under prompting by its auditors or regulators, revises its public financial information for the current period.

C) an adjustment of financial information due to an error correction.

D) All are part of the definition.

54)

All of the following are common reasons for a financial restatement except A) accounting errors.

B) noncompliance with GAAP. C) disclosure of immaterial items.

D) fraud and misrepresentation.

55) In the 2019 Audit Analytics report, what was the most common reason cited for financial restatements?

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A) securities-debt, quasi-debt, warrants, and equity B) cash flow statement classification errors C) taxes D) revenue recognition

56) Which accounting error category would including non-operating revenue in the operating category be classified as?

A) misclassification B) revenue recognition C) expense recognition D) equity

57) Which accounting error category would improper accounting for stock-based compensation plans be classified as?

A) misclassification.

B) revenue recognition.

C) expense recognition.

D) equity.

58) Which accounting error category would improper accounting for unrealized gains and losses on investments in debt and equity securities be classified as?

A) other comprehensive income.

B) revenue recognition.

C) expense recognition.

D) equity.

59) What is the best description of the reason why Kraft Heinz Co. restated its financial statements?

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A) improper accounting for asset impairments B) aggressive disclosures for non-GAAP amounts to pre-tax GAAP income C) faulty procurement practices understating cost of goods sold D) correcting the accounting for bad debt reserves

60) MagnaChip Semiconductor restated its financial statements as a result all of the following issues except?

A) accelerating revenue into earlier periods by recording revenue for unshipped products B) offering distributors undisclosed concessions through side agreements C) delaying the recording of obsolete inventory D) correcting the accounting for bad debt reserves

61)

Which theory expects management to act in the best interest of shareholders?

A) agency theory B) rights theory C) ethical egoism D) virtues theory

62) Corporate governance systems and board independence may reduce or eliminate all of the following behaviors except A) pursuing self-interests.

B) maintaining a good personal reputation.

C) bending to pressure from shareholders.

D) abuse of power.

63) The failures of corporate governance systems and earnings management can be attributed to all of the following except

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A) not setting an ethical tone at the top.

B) creating a pressure-laden culture that emphasizes egoistic goals.

C) an independent audit committee.

D) management override of internal controls.

64)

Earnings management is likely to decrease when corporate governance systems A) set an ethical tone at the top.

B) follow egoistic goals.

C) lack an independent audit committee.

D) management overrides internal controls.

ESSAY. Write your answer in the space provided or on a separate sheet of paper.

65) Distinguish between authentic leaders, transformational leadership, followership, and servant leadership. Include in your discussion the goals of each type of leadership.

66) Character and leadership go hand in hand. Explain the elements of character-based leadership.

67) What is the role of moral intensity, organizational culture, and ethical leadership in promoting ethical behavior?

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68) Discuss how moral intensity, organizational culture, and ethical leadership influence behavior in accounting.

69) Discuss the role of ethical leadership behavior in public accounting firms and how ethical leadership influences the internal communication and employee outcomes in the organization.

70) Explain what ethical leadership is in the context of ethical behavior in organizations and decision making and how ethical competence can be developed.

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71) We have many discussions about ethical behavior in this book. Describe how each of the following influence leadership behavior in accounting: ● Josephson's Six Pillars of Character· Virtue-based ethical decision making ● Usefulness of codes of ethics and the AICPA Code in making ethical decisions ● Role of moral courage in decision making ● Leadership and codes/basis for ethical behavior ● Dealing with ethical dilemmas in the workplace ● Kidder's structure to deal with ethical dilemmas and decision making ● Whistleblowing in accounting ● Role of leadership in promoting ethical behavior

72) There are many reasons organizations choose to issue financial restatements. Explain how errors in accounting and reporting can trigger restatements. Identify the common causes of financial restatements.

73) Explain which operational issues caused a need for MagnaChip Semiconductor to restate their financial statements.

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Answer Key Test name: Chap 07_6e_ Mintz 1) D 2) A 3) B 4) B 5) A 6) B 7) B 8) A 9) C 10) C 11) D 12) D 13) A 14) C 15) B 16) C 17) B 18) D 19) A 20) A 21) C 22) C 23) B 24) C 25) A 26) B Version 1

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27) B 28) B 29) B 30) A 31) C 32) A 33) C 34) D 35) B 36) C 37) D 38) B 39) B 40) A 41) C 42) B 43) D 44) C 45) B 46) B 47) C 48) A 49) A 50) D 51) B 52) B 53) A 54) C 55) D 56) A Version 1

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57) D 58) A 59) C 60) D 61) A 62) B 63) C 64) A

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65)Authentic leaders are focused on building long-term shareholder value, not in just beating quarterly estimates. Authentic leaders are individuals "who are deeply aware of how they think and behave and are perceived by others as being aware of their own and others" values/moral perspectives, knowledge, and strengths; aware of the context in which they operate; and confident, optimistic, resilient, courageous, and of high moral character. Authentic leaders acknowledge the ethical responsibilities of their roles, can recognize and evaluate ethical issues, and take moral actions that are thoroughly grounded in their beliefs and values.

Authentic leaders hold altruistic values and are concerned with achieving a common good for the group or organization for which they are responsible. Authentic leadership produces a number of positive ethical effects in followers that significantly influence the creation of an ethical organization environment and help to promote values-based decision making. Followers are likely to emulate the example of authentic leaders who set a high ethical standard. They are empowered to make ethical choices on their own without the input of the leader.

They become moral agents of the organization.

Transformational leadership is defined as a leadership approach that causes change in individuals and social systems. In its ideal form, it creates valuable and positive change in the followers with the end goal of developing followers into leaders. Enacted in its authentic form, transformational leadership enhances the motivation, morale, and performance of followers through a variety of mechanisms. These include connecting the follower's sense of identity and self to the mission and the collective identity of the organization; being a role model for followers that inspires them; challenging followers to take greater ownership for their work; and understanding the strengths and weaknesses of followers, so the leader can align followers with tasks Version 1

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that optimize their performance.

Transformational leadership is an ongoing process rather than the discrete exchanges of the transactional approach. Transformational leaders raise the bar by appealing to higher ideals and values of followers. In doing so, they may model the values themselves and use appealing methods to attract people to the values and to the leader.

The flip side of leadership is followership. The term followership is characterized as an independent relationship in which the leader's perceived legitimacy can affect the degree to which followers allow themselves to be influenced. This early work emphasizes the reciprocal relationship in which followers play an active role not only by receiving but also exerting influence.

Servant leadership advocates a perspective that leaders have a responsibility to serve their followers by helping them achieve and improve by modeling leaders' ethical values, attitudes, and behaviors that influence organizational outcomes through the fulfillment of followers' needs. The basic premise of servant leadership is leaders should put the needs of followers before their own needs. Servant leaders use collaboration and persuasion to influence followers rather than coercion and control. They understand their stewardship role and are accountable for their actions. Servant leadership helps to create an ethical, trusting organizational climate.

Trust is a key component in developing successful relationships between leaders and followers. A trusting relationship is built on shared values, respect, open communication, and accountability. Trevino et al.'s pillars of ethical leadership are the relevant behaviors that leaders can employ to demonstrate integrity to followers and build trust. The pillars are antecedents to trust and include role-modeling through visible action, the use of rewards and discipline, and communicating about ethics and values.

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Followership, servant leaders, and authenticity all share one common characteristic: leader ethicality . De Cremer and Tenbrunsel define leader ethicality as the intention to demonstrate normatively appropriate conduct and to create an environment within which others will be encouraged to act ethically and discouraged from acting unethically.

Demonstrating normatively appropriate conduct is in part determined by follower perceptions, thus leader intent is important.

Moreover, this definition takes into consideration the importance of moral perspectives and underscores the notion that ethical behavior is to some extent defined by how it is construed within the context of social prescriptions. In other words, the public interest ideal is the context within which leaders' model ethical behavior to nourish the perception that the accounting profession is an ethical profession with norms and values.

De Cremer and Tenbrunsel posit that, due to the socially construed nature of leader legitimacy, leaders are vulnerable to follower judgments. Leaders may gain legitimacy from followers when they allow themselves to receive follower influence and behave in accordance with followers' normative expectations. Thus, leadership and followership are reciprocal relationships with one influencing the other.

Organizational dissidence is best controlled when both parties strive for high ethics in their behavior and decision making.

Summary of basic characteristics Authentic Leadership: Actions grounded in beliefs and values Transformational Leadership: Causes change in individuals and social systems Followership: Reciprocal relationship; leader's perceived legitimacy influences follower's identification with those leaders.

Servant Leadership: Leaders serve followers by helping them improve by modeling leaders' ethical values, attitudes, and behaviors.

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66)Drawing from virtue ethics, character-based leadership includes: Compassion | Courage | Fairness | Honesty | Inclusiveness | Initiative | Integrity | Optimism | Perseverance | Respect | Responsibility A workplace exhibiting these attributes and a company operating within their guidelines create a moral manager and encourage followers to act ethically. Character-based leaders set an ethical tone and build an organization with strong ethical values.

It has been said that a person's character is revealed by how they act when no one is watching and by the choices they make when they believe no one will know. More importantly, when public and private behavior is consistent, it's governed by character rather than expediency or some external motive.

The word character itself is neither positive nor negative. Everyone has character, but not everyone has the attributes associated with good character. This is an important distinction because character matters— whether it's good or bad. While some personality traits may be genetic, for the most part character "happens." This cautionary verse illustrates just how easily and unconsciously it happens!

"Watch your thoughts, they become words; watch your words, they become actions; watch your actions, they become habits; watch your habits, they become character; watch your character, for it becomes your destiny."

In an organization, the character of the leader sets the tone for everyone else. When leaders demonstrate good character and expect the same from all employees, everyone benefits from the resulting inclusive, hightrust culture and the company outperforms. If, for example, everyone in an organization embraced the 11 character attributes described above, that organization and everyone who works there would benefit from three fundamental advantages (at minimum).

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More trust: When people in an organization know they are respected and valued and relied upon and that they in turn respect, value and rely upon their leaders and co-workers, a culture of mutual trust can emerge.

Honesty, integrity, and compassion nurture that trust further.

More pride: Employees want to feel proud of the organization they work for. Knowing that leadership not only talks about good character, but also demonstrates and supports the character attributes they talk about, allows employees to take pride in their work and their company.

Organizational pride keeps employees engaged with and committed to their organization.

More teamwork: When leaders and employees are motivated by purpose more than personal gain, are proud of the company they work for, and have trusting relationships with colleagues and leaders, they appreciate the value of teamwork. In fact, research has found that only high trust between co-workers and leaders supports the level of collaboration needed for challenging teamwork and that organizations who achieve this level of trust benefit from a competitive advantage through the added value and synergy of effective teamwork.

The many spectacular ethical failures back in the days of Enron have brought the need for ethical leadership back to the forefront, while highlighting the importance (and value) of cultivating a company culture based on good character. The message is clear: leading, managing, and working with good character is not only the right thing to do, it's also good business.

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67)Ethical leader behaviors help establish leader credibility (i.e., trustworthiness and expertise) as perceived by employees. Symmetrical communication mediates the influences of power sharing and people orientation on employee engagement. Both transformational and authentic leadership contain an ethical component, which also concurs with the notion of symmetrical communication. Ethical leadership behavior has emerged as a separate positive leadership style, one that is frequently being placed on top of an organization's priority list. It positively influences internal communication and employee outcomes.

Ethical leader behaviors combined with the characteristics of an issue at hand provide the foundation to determine whether employees will follow their leaders. Jones argued that ethical decisions are primarily contingent upon the characteristics of the issue at stake so that judgments of ethicality would involve a systematic evaluation of the moral intensity of the characteristics of the issue. Factors need to be evaluated for moral intensity, including the magnitude of the consequences of the moral act; the degree of social consensus that the moral act is unethical; the feelings of proximity of the moral agent to the moral act; the likelihood that the moral act would take effect; the temporal immediacy of the effect of the moral act; and the concentration of the effect. Jones's model predicts that the perceived overall intensity of a moral issue would influence the decision maker's moral judgment and, moral intent, as well as subsequent moral action.

The moral intensity of issues in an organization plays a role in whether whistleblowing will occur. The predictor of whistleblowing and that of empathy corresponds directly to the two moral intensity dimensions of seriousness of issue and proximity. The degree of social consensus that the moral act is unethical is greatly influenced by the culture of the organization and whether ethical leadership exists. Thus, an ethical leader is more attuned to the magnitude of consequences and can use Version 1

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that in the pre-action decision stage to mitigate any bystander effect.

A greater degree of harm or benefit results in an increase in moral intensity because more stakeholders are at risk and the potential negative effects of unethical actions are more serious.

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68)We could equate moral intensity with materiality issues in accounting where differences of opinion over proper accounting become more significant/intense as the amount involved increases and/or qualitative characteristics increase moral intensity—such as when an item in question masks a change in earnings or other trends.

Taylor and Curtis studied whistleblowing among public accounting seniors and found that moral intensity is one of three significant factors affecting the intention to report wrongdoing, where intention to report is measured as the likelihood of reporting and perseverance in reporting.

The other two factors were professional identity and locus commitment (organization versus colleague). The authors found that while high levels of professional identity increase the likelihood that an auditor will initially report an observed violation, the auditor's commitment to the organization drives perseverance in reporting. Auditors were more likely to report and to persevere when moral intensity is high.

Personal ethical skills are primarily managed by the organizational structure of audit firms, and rules and processes have been developed with the sole aim of limiting the audit risk and guaranteeing audit quality. Ethical competencies are managed indirectly and promoted by the idea of responsible leadership and incentives to promote exemplary behaviors. Personal and professional ethics have roles to play in cultivating responsible leadership by management of audit firms. The promotion of responsible leadership is seen within audit firms as a way to improve audit quality.

Responsible leadership in audit firms is essential to create an ethical environment within the firm. It is a critical component of setting the proper tone and encouraging members of the organization to ask probing questions when management's representations are unclear or unsubstantiated. Responsible leadership is an integral part of ethical leadership, although the latter also entails the ability to reason through Version 1

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ethical dilemmas and resolve conflicts in a morally appropriate way.

The ethical environment within an accounting firm is created through espoused values and management practices. The culture of the firm results from leadership style and may be the most important deterrent to unethical behavior. Authentic (partner) leaders gain the confidence of audit staff and managers and create a foundation for ethical decision making.

Research by Ponemon found that leaders of accounting firms set the tone of their organizations, promoting those whose personal attributes more closely reflected the leaders' perceptions and moral reasoning development. He hypothesized there is a correlation between the organizational culture created by leaders of the accounting firms and the subordinates' personal characteristics and decision-making styles.

Prior research has indicated that audit seniors' perceptions of their firm leaders and firm culture impact auditor behavior. Personal characteristics have an impact on individual behaviors. Shaub et al. found mixed evidence of "the ability of an accounting firm to either change an auditor's ethical orientation to match its own, or to provide an environment that closely matches an auditor's norms."

The dissidence that is created when individual values do not fit into the expectations of the firm might lead the individual to alter behavior to conform to firm norms, the firing of the individual from the firm, or her voluntary departure. Ponemon confirmed the existence of a selectionsocialization mechanism operating to control ethical reasoning in public accounting firms. The selection-socialization bias causes a firm to hire and promote individuals who fit into the prevailing firm culture and causes individuals unable to fit into that culture to leave.

Morris studied the influence of authentic leadership and ethical firm culture on auditor behavior. Morris gathered data from 120 practicing senior auditors representing the Big Four firms, other international firms, Version 1

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large regional firms, and local firms. Participants were asked to indicate the frequency of selected dysfunctional behavior among audit seniors.

Morris hypothesized that perceptions of authentic leadership are negatively related to the frequency of dysfunctional audit behaviors. The behaviors identified include under-reporting of time worked on an engagement, premature sign-off on audit procedures, and other dysfunctional behaviors.

The results indicate that a typical audit senior at these firms more frequently under-reports time than prematurely signing off on audit work. The results also indicate there was a significant negative correlation between all measures of authentic leadership and dysfunctional audit behaviors with few exceptions. With respect to ethical culture, there was a negative relationship between the audit seniors' perceptions of their firms as ethical, and instances of dysfunctional audit behavior. The findings support the mediation of perceptions of authenticity in leaders on the auditors' perception of ethical firm culture and on auditors' instances of dysfunctional behavior.

The results seem to indicate that the four constructs of authentic leadership, whether taken individually or in combination, have influence over the employee's perception of the ethical content of a firm's organizational culture.

The takeaway from the Morris study is that authentic leaders can help to promote an ethical culture and reduce the instances of dysfunctional auditor behavior. Authentic leaders seek to eliminate ethical dissonance.

Ethical (authentic) leaders commit to a high person-organization fit where organizational ethics are high and the culture promotes high individual ethics (High-High). Any other combination may jeopardize ethical decision making and sacrifice the public trust in the audit profession—at least in that instance.

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69)Ethical leader behaviors help establish leader credibility (i.e., trustworthiness and expertise) as perceived by employees. Symmetrical communication mediates the influences of power sharing and people orientation on employee engagement. Both transformational and authentic leadership contain an ethical component, which also concurs with the notion of symmetrical communication. While ethical leadership behavior has emerged as a separate positive leadership style, one that is frequently being placed on top of an organization's priority list, the positive influence of ethical leadership on internal communication and employee outcomes in an organization must be speculated.

Public accounting firms that have strong ethical transformational leadership and demonstrate an organizational ethical climate possess an organizational sustainability that promotes ethical behavior. The accounting profession continually needs to assess its ethical leadership and their organizational ethical work climates. Accounting organizational leaders must effectively communicate organization's ethical climate policies, procedures, and performance expectations.

Ethical leadership behaviors congruent with the firm's ethical climate behavioral mechanism expectations could better safeguard accounting firms from ethical failures, which can and have led to consequential and catastrophic loss. Understanding the relationship between the leadership styles exhibited by public accounting leaders and the effect on immediate subordinate followers' perceptions of the firm's ethical climate can provide a benchmark understanding of the status of the firm's appropriateness of leadership styles and the sufficiency of the firm's ethical climate components.

The accounting profession's status as a profession heightens the importance of strong ethical environments within accounting firms.

Understanding whether the discrepancy noted in other organizations also exists for CPA firms is an important question, given the responsibility Version 1

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that partners have in developing a strong ethical environment. In a CPA firm, partners are the leaders of the organization who are responsible for developing and framing the perceptions of acceptable organizational practices and policies. Firm leaders are extremely influential in shaping an organization's ethical environment.

Bobek, Hageman, and Radtke found that leadership development fostering the transformational leadership style is desirable for sustaining an organizational ethical awareness; that ethics training, for all levels of the CPA organization, should be continuous and ongoing; and that employees understanding of professional standards and relevant governmental regulations can minimize poor leadership's influence and subordinate ethical perceptions.

Bobek, Hageman, and Radtke examined perceptions of tax partners and non-partner tax practitioners regarding their CPA firms' ethical environment, as well as experiences with ethical dilemmas. Based on the responses of 144 tax practitioners employed at CPA firms, the results show that tax partners rate the ethical environment of their firms as stronger than non-partner tax practitioners, particularly among those who describe a self-identified ethical dilemma. The authors concluded from their study that a disconnect exists between tax partners and nonpartner tax practitioners with respect to perceptions of organizational ethics.

Reasons for this disconnect include the need for executives to personally identify with an organization and maintain the organization's image as their own, the fact that executives spend more time with external constituents than internal constituents, and a lack of awareness of the pressures faced by lower level employees.

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70)The ethical leader understands that positive relationships built on respect, openness, and trust are critical to creating an ethical organization environment. The underlying principles of ethical leadership are: integrity, honesty, fairness, justice, responsibility, accountability, and empathy.

Ethical leaders strive to honor and respect others in the organization and seek to empower others to achieve success by focusing on right action.

An ethical organization is a community of people working together in an environment of mutual respect, where they grow personally, feel fulfilled, contribute to a common good, and share in the internal rewards, such as the achievement of a level of excellence common to a practice as well as the rewards of a job well done. By emphasizing community and internal rewards, ethical leaders commit to following a virtue-oriented approach to decision making based on a foundation of values-based leadership.

John Maxwell, the internationally recognized leadership expert, said, "A leader is one who knows the way, goes the way, and shows the way."

Leaders lead by example. They set an ethical tone at the top. They lead with an attitude of "Do what I say as well as what I do." Ciulla argues that what is distinctive of leadership is the concept of vision: "Visions are not simple goals, but rather ways of seeing the future that implicitly or explicitly entail some notion of the good."

The ethical leader embraces the act of service and fosters "servant leadership." The effective leader acts as a servant to others engaged in the enterprise, not in any sense of inferiority, but as one who empowers others to achieve success by focusing on right action. The ethical leader understands the truth of our interconnectedness to each other, and that it is through our willingness to serve each other that we release our combined energy and potential to benefit the greater good of which we are all a part.

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In accounting, ethical leadership entails building an environment where those in the organization feel comfortable in talking to others to share perspectives of the importance of finding an ethical solution to problems. Internal accountants and auditors may possess ethical values, but it will mean nothing unless a supportive organization exists to help develop the courage to put those values into action. Voicing one's values when conflicts exist creates challenges that can be exacerbated by an indifferent leader and culture that operates by rationalizing unethical actions. Pressures imposed by top management to go along with financial wrongdoing under the guise of "It is expected practice around here" or "You need to be a team player" challenges a protagonist who must counter those reasons and give voice to one's values.

An ethical organization is a community of people working together in an environment of mutual respect, where they grow personally, feel fulfilled, contribute to a common good, and share in the personal, emotional, and financial rewards of a job well done. There is a shared understanding that success depends on a constellation of relationships, both internal and external, not all of which are under the organization's control, but which it can influence through the way it operates from a platform of ethical principles.

Understanding the importance of ethical leadership for organizational achievement has significant implications for leadership development.

The key to business success is getting things done and we now understand more clearly than ever before that this depends on those who manage in the middle. The ethical leader embraces the act of service and fosters "servant leadership." The effective leader acts as a servant to others engaged in the enterprise, not in any sense of inferiority, but as one who empowers others to achieve success by focusing on right action. The ethical leader understands the truth of our interconnectedness to each other, and that it is through our willingness to Version 1

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serve each other that we release our combined energy and potential to benefit the greater good of which we are all a part.

The focus of leadership development should be on producing leaders who have personal ethical competence, who are good models for those around them, and who can empower others to get the work done in ways that promote harmony and maintain good relationships. This calls for leadership development specifically focused on training ethical leaders throughout the organization.

A dominant theme in the literature on leadership is that it can and must be taught. The success of enterprises large and small depends on seeing leadership as a set of skills and competencies that can be learned through study and practice. When it comes to ethical leadership such learning must take the form of deep personal reflection guided by materials that distill the essence of moral principles and leadership insights into specific qualities or characteristics. Exhibit 1 shows example items from a set of three measures called The Ethical Leadership Scales.

Exhibit 1. The Ethical Leadership Scales Ethical Competence Scale Personal Record Form Personal Ethical Competence How we maintain our personal commitment to an ethical life Foundational How we are Characteristic grounded in s thought and action

Alway Usuall Sometime Rarel Neve Chose s in y in s in y in r in n Place Place Place Place Plac Value e

Characteristic Explanation

10–9

8–7

6–5

4–3

2–1

1.

Being Trustworthines reliable and s dependable; Being willing to admit mistakes; Being true to your word; Being worthy of

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confidence; Keeping promises

Ethical Leadership Scale Personal Record Form

Personal Qualities of the Ethical Leader Characteristic Explanation Relationship to Self

1. Acts with integrity

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Alway Usuall Sometime Rarel Neve Chose s in y in s in y in r in n Place Place Place Place Plac Value e 10–9 8–7 6–5 4–3 2–1

Keeps promises and commitments and expects others to keep theirs; Maintains loyalty to those not present; Apologizes sincerely; Acts with honesty; Takes responsibilit y and cleans up after mistakes

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Beginning with the understanding that effective ethical leadership depends on personal ethical competence, the Ethical Competence Scale is used to give respondents the experience of reflecting in a comprehensive and rigorous way on the level of their ethical competence across 30 items covering personal ethical competence, social ethical competence, and global ethical competence. This personal reflection is followed by small group discussion, simulation, and role playing focused on where and how these specific competencies apply in their industry or business. Examples of real or potential ethical breaches are raised and participants are challenged to apply creative thinking to identify strategies and solutions for dealing with these problems.

Following this rigorous focus on personal ethical competence, the Ethical Leadership Scale is used to engage participants in reflecting more specifically on the leadership qualities needed to ensure their group or team maintains positive ethical relationships in all its work.

There are 40 items on this scale covering relationship to self, relationship to others, and relationship to the whole. Techniques of role playing, simulation, and scenario writing are used to enhance this experience. In all of this work there is no substitute for deep personal engagement in the issues, because this kind of learning must move from head to heart and then from heart to heart throughout the team.

The content of this leadership learning can be summarized in the following points that identify the essentials of the learning process and its wider implications.

First of all is the fundamental understanding that ethical leadership is principle based. It is anchored in moral or natural laws that are just as real in their effect as physical laws, such as the law of gravity. Moral principles of trust, respect, integrity, honesty, fairness, equity, and compassion if honored will return benefits in many ways; if broken, they will bring negative repercussions that usually affect not only the violator Version 1

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but innocent people as well.

It follows from its grounding in moral principles that ethical leadership is focused on service. The ethical leader takes care that other peoples' priority needs are being served. This is done by forming I-Thou relationships and always treating the other person in a relationship as an end, never merely as a means to benefit oneself.

An organization's work flourishes when leaders throughout the formal structure take responsibility for ensuring that the work performed under their charge is ethically grounded. Of course, it is important that sound ethical behavior is modeled at the top, but it is the leaders in the middle who will ensure that high ethical standards are set and maintained in the units under their charge.

All leadership development begins with the conviction that leadership is a skill that can be learned. Ethical leadership is grounded in a set of competencies that can be strengthened and developed through carefully designed opportunities for reflection, dialogue, and practice.

Competence in ethical leadership can be measured through changes in perception of the leaders and by objective measures of organizational performance. Leadership development initiatives must be carefully designed to ensure that valid before and after measurements are made.

When the organization is functioning with good ethical relationships throughout, people are healthier and happier, and productivity measures improve in every way. There is an emotional bottom line that supports the financial bottom line. Ethical leadership honors the emotional needs of people for respect and meaning, which are reflected in "quantum leaps in personal and organizational effectiveness."

The influence of a well-functioning, ethically grounded organization goes far beyond its own operations. As an integral component of society that functions as a network of institutions, organizations, communities, and individuals, the ethical organization has unlimited scope for Version 1

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influencing and promoting the common good.

Ethical competence is not a replacement for good business sense or wise political judgment. But, business sense, if it is to be good, and political judgment, if it is to be wise, must be anchored in ethical leadership.

Without that clear moral guidance by those who should be practicing ethical leadership in accounting — controllers, CFOs, internal auditors, and external auditors — those in an organization who face ethical dilemmas are left on their own to navigate the choppy waters without a chart or compass. Ultimately, improved ethical leadership will positively impact the financial bottom line of the organization.

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71)An understanding of ethics begins with an analysis of values, both individual and organizational. Effective managers and leaders must be aware of their values, morals, and system of ethics and ethical decision making. Good character and integrity are integral components of ethical leadership. There must be a connection between a sound value system and the ability of the leader to use these values in his/her decision making. The Josephson Institute's Six Pillars of Character might easily be applied to a business setting. These six pillars are: Trustworthiness - honesty, integrity, reliability, loyalty, keeping promises, and not deceiving others.

Respect - using the Golden Rule or treating others as you wish to be treated, in addition to being courteous, listening to others, and accepting individual differences.

Responsibility - accountability, self-control, the pursuit of excellence, and considering consequences of our actions prior to making them.

Fairness - playing by the rules, not taking advantage of others, making informed judgments without favoritism or prejudice, and not blaming others.

Caring - kindness, compassion, and altruism, acting to minimize hardship and to help others whenever possible.

Citizenship - working to make one's community better, protecting the environment, making our democratic institutions work, and operating within the law.

Acting in accordance with these ethical values creates an ethical environment that, in turn, fosters buy-in by employees. Acting in accordance with nonethical values (wealth, power, prestige) is more likely to promote self-interested behavior that places the interests of the client, firm, or one's self-interest ahead of the public interest.

Accounting is a community with established standards that underlie ethical behavior and enable professionals to act with integrity. Integrity Version 1

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is the heart and soul of ethical behavior because it provides the proper ethical perspective to deal with internal and external pressures and set them aside to do the right thing.

Once an ethical environment is created, employees and management develop trust in one another. Good leaders garner trust. Trust can be developed in many ways but most fundamentally through leading by example. Leaders must do ethical things on a consistent basis in plain and full view for their constituents to see. Transparency is critical in creating an ethical environment.

For leaders to facilitate solutions to ethical dilemmas in the workplace, written guidelines in the form of a code of conduct are useful. A code of conduct is intended to be a guide and reference for users in support of day-to-day decision making. It is meant to clarify an organization's mission, values, and principles, and to link them with standards of professional conduct.

In the accounting profession, these standards are embodied in the codes of professional ethics of groups such as The American Institute of CPAs (AICPA) and the Institute of Management Accountants (IMA). The AICPA Code definitively places the needs and interests of the public ahead of those of a client, firm, or self-interest. The public interest ideal imparts ethical obligations to perform services with objectivity, due care, and exercise a healthy dose of skepticism in gathering and evaluating evidence.

Codes require the commitment of the company's leaders and other higher levels of management, and should address the needs of the various constituencies and stakeholders in the organization. A code is an open disclosure for the way an organization operates. It provides visible guidelines for behavior. A well-written and thoughtful code also serves as an important communication vehicle that reflects the covenant that an organization has made to uphold its most important values, dealing with Version 1

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such matters as its commitment to employees, its standards for doing business, and its relationship with the community. A code is also a tool to encourage discussions of ethics and to improve how employees/members deal with the ethical dilemmas, prejudices, and "gray areas" that are encountered in an organization/community such as the accounting profession.

Ethical dilemmas occur when important values come into conflict, and the decision maker (the leader, in many cases) must make a choice between these values. Since both values are important, success and honesty, for example, priorities must be assigned to values and one takes precedence over the other. To the extent possible, a careful balance must be preserved to maximize both values in order to avoid unethical decision making.

Kidder offers two classifications of ethical dilemmas. In the first type of dilemma, a right versus wrong dilemma, ethical issues emerge when a core moral value has been violated or ignored. When honesty is an important value to a person, and another person is found to be acting dishonestly, it is generally acknowledged that the action was unethical.

In this case, ethics is simply the obvious difference between what is right and what is wrong. In the second type of dilemma, a right versus right dilemma, however, ethical issues emerge when two core values come into conflict with each other.

When one important value raises powerful moral arguments for one course of action, while another value raises equally powerful arguments for an opposite course, we must make a choice since we can't do both. In such cases, ethics is a matter of right versus right.

Kidder also identifies four paradigms of dilemmas. In the first category of truth versus loyalty, honesty or integrity is in conflict with commitment, responsibility, or promise-keeping. In the justice versus mercy dilemma, fairness, equity, and equal application of the law Version 1

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conflict with compassion and care. The individual versus community paradigm is geared toward us versus them, self-versus others, or smaller versus larger groups. And finally, the short-term versus long-term dilemma deals with immediate needs versus future.

In his 2005 book, Moral Courage, Kidder refers to the need for "moral courage" when making difficult moral decisions. His definition of moral courage is the intersection of three concentric circles: applying values, recognizing risks, and enduring the hardship. The last one, "enduring the hardships" is the perseverance piece of the moral courage model. A leader has to be willing to persevere and stick with the "right" decision, and ignore distractions, faulty rationalizations, and justifications. In this sense the Giving Voice to Values methodology can help to respond to reasons and rationalizations given to support questionable or unethical behavior.

Moral courage of a leader requires follow through and going beyond merely thinking and talking about doing the right thing. It is the actual decision-making piece that defines the ethical leader.

Kidder also points out that the act of "whistle-blowing" is an example of moral courage. Whistle blowing consists of an individual acting with the intention of making information public, and then conveying the information to parties outside the organization who then makes it public and a part of the public record. In a true whistle blowing scenario, the information has to do with possible or actual nontrivial wrongdoings in an organization.

As we have discussed throughout the book, before blowing the whistle in accounting, a prescribed process must be followed that begins with making it known to top management including the board of directors that a material misstatement exists in the financial statements. Under Section 10A of the Securities Exchange Act of 1934, the accountant should: Version 1

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● Determine whether the violations have a material effect, quantitatively or qualitatively, on the financial statements. ● If yes, has management, or the board of directors, caused management to take remedial action, including reporting externally, if necessary? ● If no, then the individual must make a formal report of the issue with conclusions on the effect and provide the report to the board of directors.

After being informed, the board of directors has one business day to report the matter to the SEC and send a copy of the report to the accountant. If the accountant does not receive a copy by that time, then the accountant should report to the SEC within one business or resign from the engagement. Resignation does not preclude informing the SEC. If the accountant follows these prescribed steps, then there will not be a violation of the confidentiality obligation in the AICPA Code.

The accountant could turn into a whistleblower under the Dodd-Frank Financial Reform Act by either waiting 120 days to see if management takes corrective action and, if not, report the matter to the SEC. Alternatively, the accountant can report if she believes that the disclosure is necessary to prevent substantial injury to the financial interest of an entity or its investors and/or reasonably believes the entity is impeding investigation of the misconduct.

Ultimately, the ideal solution for promoting ethical behavior is not a punitive one, but a positive approach by the leaders of organizations.

Ethical behavior must be practiced by the leaders and modeled by those they lead. Ethical decision making should be acknowledged and rewarded. Ethics and leadership go hand in hand and ethics is the heart of leadership.

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72)Generally, financial statements are restated because of errors in previously issued financial statements, noncompliance with GAAP, and fraud or misrepresentation. A materiality test is done to determine if the error amount requires restatement. To be considered material, the amount in question would lead those receiving the financial statements to come to an inaccurate conclusion about the reliability and usefulness of the originally issued financial statements. An analysis of causes of restatement due to errors in accounting and reporting was made by Turner and Weirich. Results from their study identify the categories of accounting errors that trigger restatements: Category

Cause of Restatements

Revenue recognition

Improper revenue recognition, including questionable items and misreported revenue

Expense recognition

Improper expense recognition, including period of recognition, incorrect amounts; includes improper lease accounting

Misclassification

Improper classification on income statement, balance sheet, or cash flow statement; includes non-operating revenue in the operating category; cash outflow from operating activities in investment activities

Equity

Improper accounting for EPS; stock-based compensation plans, options, warrants, and convertibles

Other comprehensive income (OCI)

Improper accounting for OCI transactions, including unrealized gains and losses on investments in debt and equity securities, derivatives, and pensionliability adjustments

Capital assets

Improper accounting for asset impairments; asset-placed-in-service dates and depreciation Improper accounting for valuation of inventory, including market adjustments and obsolescence

Inventory

Reserves/allowances

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on accounts receivable, reserves for inventory, and provision for loan losses Liabilities/contingencies

Improper estimation of liability claims, loss contingencies, litigation matters, commitments, and certain accruals

73)The MagnaChip Semiconductor fraud illustrates how much can go wrong when management seeks to manage earnings through revenue recognition transactions and overriding internal controls. Financial shenanigans were used by MagnaChip to commit fraud. The following operational issues caused a need for MagnaChip Semiconductor to restate their financial statements: Channel stuffing: MagnaChip Semiconductor accelerated the recording of revenue into earlier periods by recording revenue on sales of incomplete or unshipped products.

Pull-in sales practices: MagnaChip Semiconductor offered distributors undisclosed concessions and side agreements to incentivize them to order products earlier than wanted to meet target revenue expectations.

Delaying the recording of obsolete inventory: MagnaChip Semiconductor delayed recording obsolete inventory to manipulate its reported gross margin to meet target revenue target expectations.

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Chapter 8: Auditors’ Legal Liabilities and Defenses MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

1) The key element that protects an auditor against common law liability is A) adherence to generally accepted accounting principles (GAAP).

B) adherence to generally accepted auditing standards (GAAS).

C) compliance with threats and safeguards approach.

D) maintenance of confidentiality of client information.

2)

Which of the following is not one of the four stages in an audit-related dispute?

A) events arise that create losses for the users of the financial statements B) losses are linked to material misstatements of financial statements C) legal process resolves the dispute D) auditors’ legal liability leads to financial settlement

3) Which of the following would normally be considered sufficient to demonstrate due care on the part of the auditor?

A) The auditor had their work reviewed by another audit firm.

B) The auditor cites adherence to generally accepted auditing standards (GAAS).

C) No omissions or misstatements have been found in the client's financial statements.

D) The auditor signs a statement expressing their unmodified opinion as to the fairness of the financial statements.

4) In the United States, if the auditor can demonstrate having performed services with the same degree of skill and judgment possessed by others in the profession, they can be said to have exercised A) prudence.

B) scienter.

C) nonfeasance.

D) due care.

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5) The legal precedent that evolves from legal opinions issued by judges in deciding a case and guides judges in deciding similar cases in the future is referred to as A) business law.

B) tort law.

C) common law.

D) statutory law.

6)

A privity relationship means that A) a party may be a user of the financial statements.

B) a party may sue if fraud has taken place.

C) a party's financial liability is limited.

D) a party has a contractual obligation.

7) The Ultramares v. Touche case of 1933 held that a cause of action based on negligence could not be maintained by a third party who was not in contractual privity; however, it did leave open the possibility that A) third parties that were "foreseeable" may sue for ordinary negligence.

B) third parties may sue if one of the parties in contractual privity allowed it to.

C) third parties may sue in the case of fraud or constructive fraud.

D) third parties who used the financial statements may sue.

8)

The Restatement (Second) of Torts Approach

A) expands an accountant's legal liability to third parties identified by the client as intended recipients of work.

B) limits an accountant's legal liability to only those parties with which it has a privity relationship.

C) limits an accountant's legal liability to only those parties that have been named by the client.

D) expands an accountant's legal liability to all possible users of the audited financial statements.

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9) The Rosenblum case ruling was of concern to the accounting profession because it implied that A) full joint and several liability would be reinstated.

B) all possible third party users of financial statements must be anticipated.

C) the concept of contractual privity would no longer be important.

D) financial liability would occur when scienter was proven.

10) The Credit Alliance v. Arthur Andersen & Co. case established three tests that must be satisfied for holding auditors liable for negligence to third parties. All of the following are tests described except A) knowledge by the accountant that the financial statements are to be used for a particular purpose.

B) the intention of the third party to rely on those statements.

C) some action by the accountant linking him or her to the third party that provides evidence of the accountant's understanding of intended reliance.

D) the identity of the third party must be directly known to the auditor.

11)

The unique aspect of auditors' legal liability in the Rosenblum v. Adler ruling is

A) auditors could be held liable for ordinary negligence to all reasonably foreseeable third parties.

B) auditors could be held liable for gross negligence to all reasonably foreseeable third parties.

C) auditors could be held liable for fraud to all reasonably foreseeable third parties.

D) auditors should be able to detect all deceit by management.

12)

Which of the following is not a red flag for willful evasion of the tax law?

A) keeping two sets of financial ledgers B) overstatement of deductions and exemptions C) using a false Social Security number D) claiming an exemption for a dependent

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13) When an auditor acts so carelessly in the application of professional standards that it implies a reckless disregard for the standards of due care is referred to as A) scienter.

B) fraud.

C) constructive fraud.

D) negligence.

14)

When courts find accountants liable for constructive fraud, the implication is that A) auditors should always be liable when investors lose money due to deceit.

B) accountants may be liable for fraud even when they had no knowledge of deceit.

C) auditors should be able to detect all deceit by management.

D) accountants may be held liable even to third parties to whom they did not have a duty.

15) Which of the following is not one of the defenses an auditor can use against third party lawsuits for fraud?

A) The third party was not in contractual privity.

B) The auditor did not have a duty to the third party.

C) The third party was negligent.

D) The third party did not suffer a loss.

16)

An audit engagement letter

A) offers an auditor's services to a client.

B) is required by generally accepted auditing standards (GAAS).

C) details the SEC's expectations for the audit firm for a specific engagement.

D) formalizes the relationship between the auditor and the client for a specific engagement.

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17) Which of the following is not one of the most relevant sources of civil liabilities for auditors charged with failing to adhere to the requirements of the laws in carrying out professional obligations?

A) Securities Act of 1933.

B) Private Securities Litigation Reform Act of 1995.

C) Securities and Exchange Act of 1934.

D) Sarbanes-Oxley Act of 2002.

18)

The Securities Act of 1933

A) regulates the auditing of financial statements for publicly-traded companies.

B) limits the financial liability of independent auditors except in the case of gross negligence.

C) regulates the initial offering of securities.

D) regulates which services may be performed for a publicly-traded company by an audit firm.

19)

In Grant Thornton v. Prospect High Income Fund, the Texas Supreme Court held

A) auditors were not liable for accurate accounting to anyone who reads and relies upon the audit report.

B) auditors were not liable for ordinary negligence.

C) auditors are not guarantors of accurate and reliable financial statements.

D) management is responsible for the financial statements.

20) In Grant Thornton v. Prospect High Income Fund, Grant used each of the following points to defend itself against legal liability except A) there was no evidence of a causal connection between Grant's alleged misrepresentation and the funds' alleged injury.

B) there was no evidence of actual and justifiable reliance.

C) there was no evidence of the loss suffered by the plaintiffs.

D) liability for fraudulent misrepresentations runs only to those whom the auditor knows and intends to influence, all of which was not present.

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21) Under the Securities Act of 1933, accountants who assist in the preparation of the registration statement are civilly liable if the registration statement A) contains untrue statements of material fact.

B) omits material facts required by statute or regulation.

C) omits information that if not given makes the facts stated misleading.

D) All of the choices are correct.

22) Under the Securities Act of 1933, if damages were incurred and there was a material misstatement or omission in the financial statements, the CPA will most likely lose the lawsuit unless A) the management intentionally deceived the auditors.

B) the damages were incurred to a third party that was not a signatory to the contract.

C) the CPA can shift the burden of proof to the investors.

D) the CPA rebuts the allegations.

23) Which of the following is not a valid defense to legal liability under the Securities Act of 1933?

A) materiality defense B) non-negligence defense C) due diligence defense D) lack of causation defense

24)

Which of the following is a red flag for willful evasion of the tax law?

A) keeping one set of financial ledgers B) reasonable deductions and exemptions C) claiming an exemption for a dependent D) classifying personal expenses as a business expense

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25) In establishing that the third party relied on the financial statements, one factor that works against plaintiffs establishing such reliance is A) fraud did not exist.

B) damages or loss suffered by the plaintiff would not have occurred regardless of whether the audited financial statements were misstated.

C) damages or loss suffered by the plaintiff would have occurred regardless of whether the audited financial statements were misstated.

D) negligence did not exist.

26) Under the Securities Act of 1933 and the Securities and Exchange Act of 1934, accountants may be subject to criminal penalties for A) obstruction of justice.

B) securities fraud.

C) willful violations of the securities acts.

D) violations of internal controls.

27)

The Securities and Exchange Act of 1934

A) limits the financial liability of independent auditors except in the case of gross negligence.

B) requires the filing of audited annual statements and reviewed quarterly statements.

C) regulates the initial offering of financial statements of securities.

D) regulates which services may be performed for a publicly-traded company by an audit firm.

28) Rule 10b-5 of the Securities Exchange Act of 1934 makes it unlawful for a CPA to engage in each of the following activities except

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A) employ any device, scheme, or artifice to defraud.

B) omit a material fact necessary for the financial statements to present fairly financial position, results of operations, and cash flows.

C) engage in any act, practice, or course of business to commit fraud or deceit in connection with the purchase or sale of a security.

D) make an untrue statement of material fact or omit a material fact necessary in order to make the statement made, in the light of the circumstances under which they were made, not misleading.

29) Which of the following elements do not have to be proved once a plaintiff has established the ability to sue under rule 10b-5?

A) material, factual misrepresentation, or omission B) error by auditor led to plaintiffs' loss C) reliance by the plaintiff on the financial statements D) damages suffered by plaintiff as a result of reliance on the financial statements

30)

The U.S. Supreme Court ruled in State Street v. Ernst that

A) the court may “construct” fraud based on gross negligence of the auditor.

B) the auditor engaged in an act in connection with the purchase or sale of a security that caused the loss to the plaintiff.

C) breach of duty is not required to establish fraud.

D) the auditor has no legal liability for fraud to third parties.

31) In the case of Phar-Mor v. Coopers & Lybrand, the auditors were found guilty of fraud because A) the auditors did not follow the generally accepted auditing standards (GAAS) at the time.

B) the independent audit of financial statements was not required at the time.

C) the auditors were grossly negligent and had a blatant disregard for the truth.

D) the auditors were not independent and conspired with management to steal funds.

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32) In the case of Reisman v. KPMG Peat Marwick LLP, the auditors were found guilty of fraud because A) they fraudulently recorded inventories that did not in fact exist.

B) they were aware of misrepresentations that were relied upon by others.

C) they approved moving liabilities off the balance sheet by using thousands of subsidiaries.

D) they were not independent and conspired with management.

33) Under the Private Securities Litigation Reform Act (PSLRA), if an auditor concludes that an illegal act with a material effect on the financial statements has been reported to, but not dealt with by senior management, the auditor should next report his/her conclusions to A) the Securities and Exchange Commission.

B) the company's board of directors.

C) the office of the controller/comptroller for the appropriate state.

D) the Federal Bureau of Investigation.

34) How long do management and the audit committee have to act if the independent auditor reports possible illegal acts to them?

A) one week B) one month C) three business days D) one business day

35)

The "particularity" provision in the PSLRA allows a plaintiff to A) sue the auditor.

B) assert scienter.

C) sue management.

D) assert privity.

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36) Under the PSLRA, a plaintiff must “state with particularity facts giving rise to a strong inference” of scienter. The Second Circuit opinion states that this burden could be met by alleging facts showing that the defendant had A) strong circumstantial evidence of conscious misbehavior.

B) strong circumstantial evidence of recklessness.

C) facts showing the defendant had both motive and opportunity to commit securities fraud.

D) All of the choices are correct.

37)

The Private Securities Litigation Reform Act of 1995 applies the practice of blank to auditor liability determinations.

A) risk assessment B) joint and several liability C) particularized standard D) proportionate liability

38)

What is a worrisome consequence under the joint-and-several liability principle?

A) Each negligent party is liable for the portion of the damages for which it is responsible.

B) All negligent parties are always liable for damages.

C) Only the negligent party considered to have "deep pockets" is held liable for damages.

D) Each negligent party could be held liable for the total of damages suffered.

39) Which of the following is not a requirement of Section 10A of the Securities Exchange Act of 1934 for auditors of public companies with respect to illegal acts?

A) determine whether it is likely that an illegal act has occurred.

B) determine what the possible effect of the illegal act is on the financial statements.

C) determine whether management participated in the illegal act.

D) inform management and assure that the audit committee knows about any material illegal act that has been detected.

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40) Under the rules of the Sarbanes-Oxley Act of 2002 (SOX), who must certify the public reports filed with the SEC? A) the independent auditor B) the CEO and the independent auditor C) the CEO and CFO D) the CFO and the board of directors

41) Under section 302 of SOX, the financial statement certifying officials must include in their certification that A) a list of all deficiencies in the internal controls and information on any fraud that involves employees who are involved with internal activities has been created.

B) the auditors are responsible for the internal controls and have evaluated and reported on them.

C) all changes in internal controls or related factors that could have a negative effect on the internal controls have been made.

D) the audit report was unmodified.

42)

What argument can be made that SOX may not be effective in reducing fraud?

A) It is not as stringent as international standards.

B) The SEC has many laws for many years that have not seemed to make much of a difference.

C) The penalties under Sarbanes-Oxley are especially stringent, so it may not be enforced.

D) Civil and criminal penalties are not effective in preventing financial fraud.

43) is

The section of SOX that requires management to prepare a report on its internal controls

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A) Section 302.

B) Section 404.

C) Section 808.

D) Section 10A(b).

44) A payment made to foreign government officials to ensure that they do what is expected given their job requirements can be characterized as a(n) A) bribe.

B) asset misappropriation.

C) facilitating Payment.

D) legal Payment.

45) A payment made to induce a foreign government official to do something they might not otherwise be required to do is a(n) A) bribe.

B) asset misappropriation.

C) facilitating Payment.

D) legal Payment.

46) Which of the following are an affirmative defense for those accused of violating the FCPA? A) The payment is lawful under the written laws of the foreign country.

B) The payment can be made for reasonable and bona fide expenditures.

C) Both that the payment is lawful under the written laws of the foreign country and that the payment can be made for reasonable and bona fide expenditures are affirmative defenses.

D) None of these choices are correct.

47)

Which of the following are violations of the Foreign Corrupt Practices Act (FCPA)?

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A) made improper payments to foreign officials to obtain regulatory and formulary approvals.

B) made improper payments to foreign officials to obtain sales.

C) made improper payments to foreign officials to obtain increased prescriptions for the company's pharmaceutical products.

D) All of these choices are correct.

48)

The FCPA requires all SEC registrants to have each of the following except

A) maintain internal accounting controls.

B) ensure all transactions are authorized by management and recorded properly.

C) maintain information systems that prevent fraudulent activities that violate the FCPA. D) maintain adequate books and records to fairly reflect an issuer's transactions and disposition of assets.

49) Which term means a person knew or should have known that their actions were likely to cause harm?

A) negligence B) recklessness C) strict Liability D) intent

50) Which term refers to a person acting in a way that breaches their duty to another that causes harm?

A) negligence B) recklessness C) strict Liability D) intent

51) In what situation can an individual be held liable for harm no matter what their mental state was?

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A) negligence B) recklessness C) strict Liability D) intent

52) A defendant is liable for injuries when he acted with willfulness. Another term for willfulness is A) negligence.

B) recklessness.

C) strict Liability.

D) intent.

53) The name of the term used to describe deficiencies in internal control over financial reporting where there is a reasonable possibility that a material misstatement will not be detected on a timely basis is called A) significant deficiency.

B) recklessness.

C) material weakness.

D) negligence.

54) The name of the term used to describe issues that are important enough to merit attention from those responsible for oversight over financial reporting is commonly called A) significant deficiency.

B) recklessness.

C) material weakness.

D) negligence.

55)

The SEC requires a change in auditors to be disclosed as follows

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A) disclosed only in periodic reports.

B) disclosed in an 8-K report.

C) disclosed in ten business days after determination of need for restatement.

D) disclosure is not required.

56)

Which of the following is not required of management under Section 302 of the SOX?

A) review their disclosure controls and procedures quarterly B) identify key control exceptions and determine which are internal control deficiencies C) assess each internal control deficiency's impact on the audit report D) identify and report significant control deficiencies on material weaknesses to the audit committee and independent auditor

57)

The problem of a compliance approach in implementing standards is that it can result in A) achieving informal compliance without considering ethical consequences.

B) achieving a true and fair view with respect to the auditor's report.

C) achieving a dual system of boards of directors.

D) achieving formal compliance without considering ethical consequences.

58) Which of the following would eliminate the ability of a plaintiff to prevail under Rule 10b-5?

A) no reliance by the plaintiff on the financial statements.

B) a factual misrepresentation.

C) the intent to deceive, manipulate, or defraud.

D) damages suffered.

59) In FCPA matters, the following would be considered effective compliance program policies except

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A) dedicated resources for compliance of standards.

B) experienced personnel in compliance functions.

C) compliance personnel are independent of management.

D) unclear reporting structure for compliance personnel.

60) In FCPA matters, the following would be considered effective compliance program policies except A) few resources dedicated to compliance of standards.

B) auditing of compliance functions.

C) availability of compliance expertise on the board.

D) clear reporting structure for compliance personnel.

61)

In the Miller Energy Resources case, the SEC found that

A) held the auditors were not liable because they exercised due care and professional skepticism.

B) held the auditors liable because they failed to gather sufficient, competent evidential matter to assess the value of assets on the financial statements.

C) held the auditors liable because they colluded with management to misrepresent the value of assets on the financial statements.

D) the auditors were not liable because they met all professional standards.

62) In Louisiana School Employees’ Retirement System v. Ernst & Young, in which the Sixth Circuit Court of Appeals affirmed the dismissal of a securities fraud complaint against EY, the opinion of the court A) held the auditors legally liable because they failed to exercise due care and to demonstrate professional skepticism.

B) held the auditors legally liable because they failed to gather sufficient, competent evidential matter to warrant the expression of an opinion.

C) held the auditors not legally liable because the plaintiff could not plead with particularity that the audit work was so deficient as to amount to no audit at all.

D) held the auditors were not legally liable because they met all professional standards.

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63)

In the Joker & Wild case, the main issue involves

A) the accounting manager’s misappropriation of assets and writing down inventory for market declines to cover theft.

B) the accounting manager’s violation of the law by taking improper accounting of tax advantaged investment.

C) accelerating revenues to commit fraud.

D) collusion between the auditors and company management.

64) The QSGI case raises questions regarding the actions of the CEO and chairman of the board who A) accelerated revenue into an earlier period without proper documentation.

B) delayed expenses into a later period through the use of reserves.

C) violated the Foreign Corrupt Practices Act. D) circumvented internal controls for inventory and falsified records.

65)

The defendant-auditors in the Anjoorian case argued, in their defense, that

A) to be found guilty to third parties, the court must find that an accountant had contemplated a specific transaction for which the financial statement will be used and that no such transaction was contemplated.

B) the plaintiff's theory of damages did not meet the foreseen legal criteria.

C) they had no liability to the client because the client did not rely on the audited financial statements.

D) they followed generally accepted auditing standards.

66)

In the Vertical Pharmaceuticals case, Deloitte & Touche was sued because

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A) vertical claimed the firm's false accusations of fraudulent conduct led to the withdrawal of another public company's planned acquisition of Vertical.

B) deloitte failed to issue an audit report on a timely basis thereby leading to the withdrawal by another public company's planned acquisition of Vertical.

C) vertical claimed Deloitte committed fraud in its audit of Vertical.

D) deloitte issued a modified opinion (adverse) on Vertical's financial statements thereby leading to the withdrawal by another public company's planned acquisition of Vertical.

67) Kay and Lee performed an audit required for Holligan Industries to extend a loan with Second National Bank & Trust. Kay and Lee may be liable for A) Second National Bank & Trust declining to extend the loan.

B) ordinary negligence to the bank that loaned money to Holligan because the firm did not discover improper accounting for revenue and assets.

C) gross negligence to the bank that loaned money to Holligan because the firm did not discover improper accounting for receivables and inventory.

D) Holligan declaring bankruptcy without a going-concern emphasis of matter.

68)

The ethical dilemma in the Alexion case can best be described as

A) the external auditors are being blocked by the client in attempting to verify accounting treatment of oil drilling services.

B) the Director of International Accounting questions the revenue recognition for oil drilling overseas.

C) gross negligence on behalf of the auditors to account for oil inventory.

D) improper payments to foreign officials and other third parties.

69)

The ethical dilemma in the Biotechnologies case can best be described as A) improper revenue recognition.

B) independence violations by an auditing firm.

C) facilitating payments to government officials.

D) bribery of U.S. government officials.

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70) The report provided by PwC to Billy Muldoon, CFO, identified which material weaknesses?

A) inadequate controls over financial reporting B) related party transactions, impaired assets, and off-balance-sheet entities C) impaired assets, falsified bank account, and facilitating payments D) fictitious revenue, contingent liabilities, and facilitating payments

71) The legal liability of the auditors in the Joker & Wild case can best be described as resulting from A) liability for gross negligence that constituted fraud.

B) no liability because the auditors performed their duties in accordance with GAAS. C) liability for failing to assess current market values of inventory.

D) improper accounting for transactions involving management override.

ESSAY. Write your answer in the space provided or on a separate sheet of paper.

72) Distinguish between an auditor's legal liability under common law and statutory law.

73) Cite specific cases to distinguish between an auditor’s legal liability under common law and statutory law.

74) Describe the steps auditors should take to protect themselves against allegations that fraud went undetected during the audit.

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75) The following clause was included in the engagement letter between Limits and Lobits, CPAs (L&L) and Fair, Inc., an audit client of (L&L).

76) Assume a securities lawyer has just received a phone call from her client, the Chief Financial Officer (CFO) of XYZ Corporation, and was informed that a securities lawsuit may be filed against her client by a group of the company's shareholders. XYZ's share price recently dropped from $40 to $4 per share after the company announced that it had to restate its quarterly results. The shareholders also learned that the CFOs compensation package ($20 million) is tied to the attainment of a $40 common stock share price. Although her client is innocent, the attorney believes the shareholders will view this as a case of securities fraud and file the suit against the CFO, alleging that due to the large compensation, the client stood to gain from reaching the share price, and with the client's ability to influence the company's revenue, the CFO possessed the motive and opportunity to defraud XYZ's investors.

Why might the facts of this case lead the attorney to conclude that a lawsuit against her client is imminent? How might the attorney assert a valid "good faith" defense?

77) Auditors may be held liable to both their clients and third parties under common law. a. What must a client prove to recover its losses from an auditor under common law? b. What must a third party prove to recover losses from an auditor under common law? c. How does an auditor's ethical obligations and liability under common law intersect?

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78) Lotus Hospitality, a U.S. publicly-owned company doing business in China, deals with state-owned enterprises in a variety of countries. It is common for Chinese companies to pay custom officials in these countries amounts ranging from $100–$500 to enable their goods to be off-loaded at the receiving docks in each country. To show its appreciation for the many years of doing business in these countries, Lotus invited 50 government officials and employees of stateowned enterprises to attend the Olympic Games in China at the company's expense, and ultimately paid for such guests as well as some spouses and others who attended along with them. Sponsored guests were primarily from countries in Africa and Asia, and they enjoyed three- and four-day hospitality packages that included event tickets, luxury hotel accommodations, and sightseeing excursions valued at $12,000 to $16,000 per package. In return for the generosity of Lotus Hospitality, the state-owned enterprises promised to give preference to Chinese companies when multi-million dollar contracts are awarded.

Describe the nature of these payments under the Foreign Corrupt Practices Act (FCPA) and assess their legality. What are the potential ethical issues of allowing certain types of payments under the Act?

79) Do considerations of culture have a place in the FCPA? Discuss in general and with respect to Hofstede's cultural values.

80) Explain the provisions of section 302 of the Sarbanes-Oxley Act including obligations of officers; nature and scope of assertions; accounting requirements; and legal liability of officers.

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81) In Chapter 4 we discussed the rules for independence. Auditor violations of independence can cause legal liability issues for the individual auditor and, perhaps, the audit firm. Describe situations where auditor legal liability has occurred as a result of independence violations and identify other situations addressed in the AICPA Code that could lead to legal liability.

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Answer Key Test name: Chap 08_6e_ Mintz 1) B 2) D 3) B 4) D 5) C 6) D 7) C 8) A 9) B 10) D 11) A 12) D 13) C 14) B 15) A 16) D 17) B 18) C 19) A 20) C 21) D 22) D 23) B 24) D 25) C 26) C Version 1

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27) B 28) B 29) B 30) A 31) C 32) B 33) B 34) D 35) B 36) D 37) D 38) D 39) C 40) C 41) A 42) D 43) B 44) C 45) A 46) C 47) D 48) C 49) B 50) A 51) C 52) D 53) C 54) A 55) B 56) C Version 1

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57) D 58) A 59) D 60) A 61) B 62) C 63) A 64) D 65) A 66) A 67) C 68) D 69) A 70) A 71) B

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72)Common law Common-law liability evolves from legal opinions issued by judges in deciding a case. These opinions become legal principles that set a precedent and guide judges in deciding similar cases in the future.

Statutory law reflects legislation passed at the state or federal level that establishes certain courses of conduct that must be adhered to by covered parties.

Common-law liability requires the auditor to perform professional services with due care. Evidence of having exercised due care exists if the auditor can demonstrate having performed services with the same degree of skill and judgment possessed by others in the profession.

Typically, an auditor would cite adherence to generally accepted auditing standards as evidence of having exercised due care in conducting the audit. Due care includes exercising the degree of professional skepticism expected in the audit of financial statements.

An accountant has a contractual obligation to the client that creates a privity relationship. A client can bring a lawsuit against an accountant for failing to live up to the terms of the contract, asserting breach of contract, and other tort actions. When privity exists, plaintiffs must demonstrate all of the following: 1. They suffered an economic loss.

2. Auditors did not perform in accordance with the terms of the contract, thereby breaching that contract.

3. Auditors failed to exercise the appropriate level of professional care related to tort actions.

4. The breach of contract or failure to exercise the appropriate level of care caused the loss.

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exercise due care or the standard of care that other accountants would have done in similar situations.

Statutory Law Auditors may have (statutory) legal liability under the Securities Act of 1933 and the Securities Exchange Act of 1934. These statutory liabilities may lead to convictions for crimes, provided their conduct was "willful."

The Securities Act of 1933 regulates the disclosure of information in a registration statement for a new public offering of securities (i.e., IPO).

Companies must file registration statements (S-1, S-2, and S-3 forms) and prospectuses that contain financial statements that have been audited by an independent CPA. Accountants who assist in the preparation of the registration statement are civilly liable if the registration statement (1) contains untrue statements of material facts, (2) omits material facts required by statute or regulation, or (3) omits information that if not given makes the facts stated misleading.

Section 11 of the Securities Act of 1933 imposes a liability on issuer companies and others, including auditors, for losses suffered by third parties when false or misleading information is included in a registration statement. Any purchaser of securities may sue: The purchaser generally must prove that (1) the specific security was offered through the registration statements, (2) damages were incurred, and (3) there was a material misstatement or omission in the financial statements included in the registration statement. The plaintiff need not prove reliance on the financial statements unless the purchase took place after one year of the offering.

If items (2) and (3) are proven, it is a prima facie case (sufficient to win against the CPA unless rebutted) and shifts the burden of proof to the accountant, who may escape liability by proving the following: (1) after reasonable investigation, the CPA concludes that there is a reasonable basis to believe that the financial statements were true and there was no Version 1

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material misstatement (the materiality defense); (2) a "reasonable investigation" was conducted (the due diligence defense); (3) the plaintiff knew that the financial statements were incorrect when the investment was made (the knowledge of falsehood defense); or (4) the loss was due to factors other than the material misstatement or omission (the lack of causation defense).

An accountant might argue that the false or misleading information is not material and thus should not have an impact on the purchaser's decision-making process. The SEC and the courts have attempted to define materiality. The term material describes the kind of information that an average prudent investor would want to have so that he can make an intelligent, informed decision whether or not to buy the security.

Thus, it is linked to objectivity. A material fact is one that, if correctly stated or disclosed, would have deterred or tended to deter the average prudent investor from purchasing the securities in question. The term does not cover minor inaccuracies or errors in matters of no interest to investors. Facts that tend to deter a person from purchasing a security are those that have an important bearing upon the nature or condition of the issuing corporation or its business.

To establish a due diligence defense, the defendant must prove that a reasonable investigation of the financial statements of the issuer and controlling persons was conducted. As a result, there was no reason to believe any of the information in the registration statement or prospectus was false or misleading. To determine whether a reasonable investigation has been made, the law provides that the standard of reasonableness is that required of a prudent person in the management of his own property. The burden of proof is on the defendant, and the test is as of the time the registration became effective. The due diligence defense, in effect, requires proof that a party was not guilty of fraud or negligence.

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The due diligence defense available to the auditor under Section 11 requires that the auditor has made a reasonable investigation of the facts supporting or contradicting the information included in the registration statement. The test is whether a "prudent person" would have made a similar investigation under similar circumstances.

The Securities Exchange Act of 1934 regulates the ongoing reporting by companies whose securities are listed and traded on stock exchanges.

The Act requires ongoing filing of quarterly (10-Q) and annual (10-K) reports and the periodic filing of an 8-K form whenever a significant event takes place affecting the entity, such as a change in auditors.

Entities having total assets of $10 million or more and 500 or more stockholders are required to register under the Securities Exchange Act. The form and content of 10-K and 10-Q filings are governed by the SEC through Regulation S-X (which covers annual and interim financial statements) and Regulation S-K (which covers other supplementary disclosures).

Section 18 of the Act imposes liability on any person who makes a material false or misleading statement in documents filed with the SEC. The auditor's liability can be limited if the auditor can show that she "acted in good faith and had no knowledge that such statement was false or misleading." However, a number of cases have limited the auditor's good-faith defense when the auditor's action has been judged to be grossly negligent.

The liability of auditors under the act often centers on Section 10 and Rule 10b-5. These provisions make it unlawful for a CPA to (1) employ any device, scheme, or artifice to defraud; (2) make an untrue statement of material fact or omit a material fact necessary in order to make the statement made, in the light of the circumstances under which they were made, not misleading; or (3) engage in any act, practice, or course of business to commit fraud or deceit in connection with the purchase or Version 1

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sale of the security.

Once a plaintiff has established the ability to sue under Rule 10b-5, the following elements must be proved: (1) a material, factual misrepresentation or omission, (2) reliance by the plaintiff on the financial statements, (3) damages suffered as a result of reliance on the financial statements, and (4) the intent to deceive, manipulate, or defraud (scienter).

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73)Common law cases In the 1933 landmark case, Ultramares v. Touche, the New York State Court of Appeals held that a cause of action based on negligence could not be maintained by a third party who was not in contractual privity.

The court did leave open the possibility that a third party could successfully sue for gross negligence that constitutes fraud and actual fraud.

The importance of the Ultramares decision is that third parties (i.e., Ultramares) without privity could sue if negligence was so great as to constitute gross negligence. The opinion of the New York Court of Appeals was written by Judge Benjamin Cardozo.

If a liability for negligence exists, a thoughtless slip or blunder, the failure to detect a theft or forgery beneath the cover of deceptive entries, may expose accountants to a liability in an indeterminate amount for an indeterminate time to an indeterminate class [third parties]. The hazards of a business on these terms are so extreme as to [raise] doubt whether a flaw may not exist in the implication of a duty that exposes to these circumstances.

The Ultramares decision was the first of three different judicial approaches to deciding the extent of an accountant's liability to third parties. The other two are the Restatement (Second) of the Law of Torts approach and the foreseeable third-party approach.

With respect to liability to third parties, while the Ultramares decision established a strict privity standard, a number of subsequent court decisions in other states moved away from this standard over time. The New York Court of Appeals expanded the privity standard in the case of Credit Alliance v. Arthur Andersen & Co. to include a near-privity relationship between third parties and the accountant. In the case, Credit Alliance was the principal lender to the client and demonstrated that Andersen had known Credit Alliance was relying on the client's Version 1

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financial statements prior to extending credit. The court also ruled that there had been direct communication between the lender and the auditor regarding the client.

The Credit Alliance case establishes the following tests that must be satisfied for holding auditors liable for negligence to third parties: (1) knowledge by the accountant that the financial statements are to be used for a particular purpose; (2) the intention of the third party to rely on those statements; and (3) some action by the accountant linking him or her to the third party that provides evidence of the accountant's understanding of intended reliance.

The "middle ground" approach followed by the vast majority of states (and federal courts located within those states) expands the class of third parties that can successfully sue an auditor for negligence beyond nearprivity to a person or limited group of persons whose reliance is (actually) foreseen, even if the specific person or group is unknown to the auditor.

The courts have deviated from the Ultramares principle through a variety of decisions. For example, a federal district court in Rhode Island decided a case in 1968, Rusch Factors, Inc. v. Levin, that held an accountant liable for negligence to a third party that was not in privity of contract. In that case, Rusch Factors had requested financial statements prior to granting a loan. Levin audited the statements, which showed the company to be solvent when it was actually insolvent. After the company went into receivership, Rusch Factors sued, and the court ruled that the Ultramares doctrine was inappropriate. In its decision, the court relied heavily on the Restatement (Second) of the Law of Torts.

The Restatement (Second) of the Law of Torts approach, sometimes known as Restatement 552, expands accountants' legal liability exposure for negligence beyond those with near privity (actually foreseen) to a small group of persons and classes who are or should be foreseen by the Version 1

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auditor as relying on the financial information. This is known as the foreseen third-party concept because even though there is no privity relationship, the accountant knew that that party or those parties would rely on the financial statements for a specified transaction.

A majority of states now use the modified privity requirement imposed

by Section 552 of the Restatement (Second) of the Law of Torts. The Restatement modifies the traditional rule of privity by allowing nonclients to sue accountants for negligent misrepresentation, provided that they belong to a "limited group" and provided that the accountant had actual knowledge that his or her professional opinion would be supplied to that group. In some state court decisions, a less restrictive interpretation of Section 552 has been made. For example, a 1986 decision by the Texas Court of Appeals in Blue Bell, Inc. v. Peat, Marwick, Mitchell & Co. (now KPMG) held that if an accountant preparing audited statements knows or should know that such statements will be relied upon, the accountant may be held liable for negligent misrepresentation.

A third judicial approach to third-party liability expands the legal liability of accountants well beyond Ultramares. The reasonably foreseeable third-party approach results from a 1983 decision by the New Jersey Supreme Court in Rosenblum, Inc. v. Adler. In that case, the Rosenblum family agreed to sell its retail catalog showroom business to Giant Stores, a corporation operating discount department stores, in exchange for Giant common stock. The Rosenblum's relied on Giant's 1971 and 1972 financial statements, which had been audited by Touche (now Deloitte & Touche). When the statements were found to be fraudulent and the stock was deemed worthless, the investors sued Touche. The lower courts did not allow the Rosenblum's claims against Touche on the grounds that the plaintiffs did not meet either the Ultramares privity test or the Restatement standard. The case was taken Version 1

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to the New Jersey Supreme Court, and it overturned the lower courts' decision, ruling that auditors can be held liable for ordinary negligence to all reasonably foreseeable third parties who are recipients of the financial statements for routine business purposes.

The legal liability of accountants is not limited to audited statements. In the 1967 case 1136 Tenants Corp. v. Max Rothenberg & Co. an accounting firm was sued for negligent failure to discover embezzlement by the managing agent who had hired the firm to "write up" the books, which did not include any audit procedures. The firm was held liable for failure to inquire or communicate about missing invoices, despite a disclaimer on the financial statements informing users that "No independent verification were undertaken thereon." The firm moved to dismiss the case, but the court denied the motion and held that even if a CPA "acted as a robot, merely doing copy work," there was an issue as to whether there were suspicious circumstances relating to missing invoices that imposed a duty on the firm to warn the client.

Auditor legal liability to third parties is summarized in Exhibit 6.2.

Exhibit 6.2 Auditor Legal Liability to Third Parties Legal Approach Case

Legal Principle

Legal Liability to Third Parties

Ultramares

Ultramares Privity (only clients can v. Touche sue)

Possibly gross negligence that constitutes (constructive) fraud

Near-privity relationship

Credit Alliance

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Three-pronged approach: Ordinary knowledge of accountant negligence that the statements will be used for a particular purpose; intention of third party to rely on those statements; some action by third party that provides evidence of the accountant’s understanding

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of intended reliance Restatement (Second) of the Law of Torts Foreseeable third party

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Rusch Factors

Actually foreseen thirdparty users

Rosenblum

Reasonably foreseeable third-party users

Ordinary negligence beyond nearprivity Ordinary negligence with reliance on the statements

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Two court decisions illustrate the application of Section 11 of the Securities Exchange Act of 1933 to securities registration matters: Escott v. BarChris Construction Corp. and Bernstein v. Crazy Eddie, Inc. (These cases are summarized in Exhibits 6.4 and 6.5, respectively.)

In Escott v. BarChris Construction Corp., the company issued a registration statement in 1961 in connection with its public offering of convertible bonds. The statements included audited financial statements

by Peat, Marwick, Mitchell & Co. The financial statements included material overstatements of revenues, current assets, gross profit, and backlog of sales orders and material understatements of contingent liabilities, loans to company officers, and potential liability for customer delinquencies. BarChris's worsening financial position resulted in a default on interest payments and the company eventually declared bankruptcy. Barry Escott and other investors sued BarChris's executive officers, directors, and the auditors under Section 11 of the Securities Act, citing a lack of appropriate professional care during the conduct of the audit. The judge ruled that the auditor's actions in reviewing events subsequent to the balance sheet date were not conducted with due diligence because the senior auditor in charge of reviewing these events had not spent sufficient time and accepted unconvincing answers to key questions. The court determined that there had been sufficient warning signs that further investigation was necessary. The auditors' failure to perform a reasonable investigation of subsequent events did not satisfy Section 11(b) and resulted in their liability to investors in BarChris's bonds.

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purchasers of the company's stock prior to the disclosure of the fraudulent financial statements. They sued Peat Marwick, the board of directors, and others, alleging that the accounting firm had violated GAAS and GAAP by failing to uncover the company's fraudulent and fictitious activities. The plaintiffs were able to show that they suffered a loss and that the certified financial statements in the registration statements and prospectuses had been false and misleading, in violation of Sections 11 and 12 of the Securities Acts of 1933. The court decided the plaintiffs did not have to prove fraud or gross negligence, only that any material misstatements in the registration statements were misleading and that they had suffered a loss. In this case, the auditor was unable to prove that they had exercised appropriate due professional care to rebut the claim.

An important case that strengthens the scienter requirement is the 1976 U.S. Supreme Court reversal in Ernst & Ernst v. Hochfelder. The U.S. Court of Appeals had ruled in favor of Hochfelder and reversed the lower court opinion. The court decision includes this statement: "One who breaches a duty of inquiry and disclosure owed another is liable in damages for aiding and abetting a third party's violation of Rule 10b-5 of the Securities Exchange Act of 1934 if the fraud would have been discovered or prevented but for the breach, and that there were genuine issues of fact as to whether [Ernst] committed such a breach, and whether inquiry and disclosure would have led to discovery or prevention of the... fraud."

The U.S. Supreme Court reversed the lower court's decision that a private cause of action can come under Rule 10b-5. The Supreme Court ruled that a private cause of action for damages does not come under Rule 10b-5 in the absence of any allegation of scienter. The Court cited the language in Section 10 that it is unlawful for any person to use or employ any manipulative or deceptive device or contrivance in Version 1

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contravention of SEC rules. The Court ruled that the use of those words clearly shows that it was intended to prohibit a type of conduct quite different from negligence. The term manipulative connotes intentional or willful conduct designed to deceive or defraud investors, a type of conduct that did not exist in the case.

In a footnote to the decision, the Court recognized that in certain areas of the law, recklessness is considered to be a form of intentional conduct for the purpose of imposing liability for some act, thereby providing potential exposure to auditors for gross negligence under the Securities Exchange Act.

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74)The role of the external auditor is to perform an audit in accordance with generally accepted auditing standards (GAAS) upon which the auditor renders an independent opinion whether those statements have been prepared in accordance with generally accepted accounting principles (GAAP) that have been consistently applied and contains full and fair disclosures of information the public needs to know. The auditor's examination of client-prepared financial statements is designed to evaluate whether any material misstatements in the financial statements exist as a result of fraud or illegal acts.

The audit must be carried out with objectivity, due care, and professional skepticism. Auditors are not guarantors that fraud will be detected.

Instead, the opinion provides reasonable assurance that the financial statements are free of material misstatements due to fraud. As long as the auditor meets these standards, a due diligence defense can be asserted.

Here are four key questions to answer that may help successfully defend a lawsuit alleging auditor malpractice.

Was the audit done in accordance with professional standards?

GAAS apply to the audits of all entities while the auditing standards of the Public Company Accounting Oversight Board (PCAOB) applies to registrants with the SEC. A key standard is Consideration of Fraud in a Financial Statement Audit (AU-C section 240). This standard outlines the process auditors must go through as they consider the possibility that fraud could occur within the company. Was the issue of fraud appropriately considered, and were audit procedures designed accordingly? Did the audit team thoughtfully consider the issue of fraud and thoroughly examine any possible issues before deciding on a scope of work as it relates to fraud.

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and the rationalizations that are typically given to rationalize the fraud. It is critically important to carefully assess management's representations with respect to assertions in the financial statements and to gather sufficient, competent evidential matter to support those assertions.

During the course of the audit, auditors must document due care and professional skepticism as these are areas often probed during litigation.

Do the working papers show that the auditors completed all the procedures suggested by the audit program?

Auditors do have some latitude in designing audit procedures, based on their evaluation of materiality and of the risks facing the company and the results of testing. This is an area in which the auditors are likely to get tripped up in a lawsuit, however, if their documentation procedures are not thorough.

It is important for auditors to determine whether any problems discovered during audit testing were dealt with appropriately. For example, if the auditors' testing revealed that documentation did not support numbers in a certain area of the financial statements (or documentation was not available), then the auditors must follow this with additional analysis and/or procedures.

Did staff, managers, and partners sign off on the work programs appropriately?

In addition to performing all the appropriate audit procedures, the auditors must document this work (and relevant issues to consider) in the work programs. Do the work programs reflect the work actually done?

Was a box checked or a space signed only if the work was actually done? This can be a tedious thing to analyze, as the expert must go through all of the work programs in conjunction with the workpapers, and make sure that the representations in the work programs match the documented work.

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partner/technical review partner reviewing the working papers?

The engagement partner has ultimate responsibility for the audit. Audit firms demonstrate due care when they have a second partner review those work papers including any that indicate differences of opinion with management and how they were resolves as well as communications with the audit committee. An important consideration is whether the firm reviewed management's report on internal controls over financial reporting and whether the firm issued its own report based on that assessment. This is required under section 404 of SOX. PCAOB inspections oftentimes identify internal control assessments as deficiencies based on inspections of audit working papers.

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75)Fair, Inc. agrees to release, indemnify, and hold Limits & Lobits, CPAs (its partners, heirs, executors, personal representatives, successors, and assigns) harmless from any liability and costs resulting from fraud caused by or participated in by management of Fair, Inc. Do you think such a clause is ethical? Use ethical reasoning to support your answer with reference to professional standards.

With the continuing focus on management fraud and an auditor’s responsibility to detect fraud, some CPAs have expressed an interest in including an indemnification clause covering management fraud in engagement letters. Where management fraud is not detected by the auditor and litigation ensues, the success of this clause in protecting the CPA would be dependent upon the views of the governing jurisdiction.

An indemnification or hold harmless clause in an engagement letter typically provides that the client will indemnify or hold the CPA harmless in the event the CPA sustains a loss resulting from claims arising from the CPA's work on the subject engagement. Indemnification clauses are not intended to preclude the CPA from incurring liability for professional malpractice. Instead, such a clause is intended to preclude liability where the client knowingly makes misrepresentations to the CPA, causes or participates in a fraud, conceals information from the CPA, or otherwise leads the CPA astray.

Where permitted, indemnification clauses may provide valuable benefits to the CPA. For example, the inclusion of an indemnification clause could prove to be a deterrent to a client considering a potential claim against a CPA firm. Recognizing the existence of the indemnification clause, the client may view an action against the CPA as being without potential benefit. Further, for the CPA and client desiring to keep the engagement risk and reward equation in balance, the use of an indemnification clause could provide support for the CPA's adjusting the fee for the subject services. Also, the upfront discussion and use of such Version 1

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a clause affords the parties the opportunity to address their specific risk management and risk allocation needs before the engagement commences and thereby provide both parties with knowledge of their individual limits and exposures.

The ethical issue turns on whether these clauses could jeopardize an auditor's performance and independence. Given that independence is both a factual determination as well as the appearance of independence, it would seem that a reasonable observer might conclude that an auditor(s) is less diligent in doing all that is necessary to find fraud if, for example, the audit is late and above budget because of the limitation of liability. On the other hand, the auditor(s) liability to investors and other third-party users cannot be similarly limited.

For some time the position of the SEC and PCAOB with regard to the use of an indemnification provision by a CPA/CPA firm auditing a public company has been that an agreement that provides complete indemnification to an auditor impairs independence in attest engagements. Prior to the revision to the AICPA Code, such indemnification clauses were permitted so that they were acceptable by the profession for non-public companies.

The Revised AICPA Code contains a provision under section 1.228.020, Indemnification of Attest Client, that indemnification clauses in audit engagement letters create a threat to independence that cannot be reduced to an acceptable level by the application of safeguards if the covered member (CPA on the attest engagement team) enters into an agreement providing, among other things, that the covered member indemnifies the attest client for damages, losses, or costs arising from lawsuits, claims, or settlements that related, directly or indirectly to the attest client's acts. The covered member's independence would be impaired under these circumstances.

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best viewed through the prism of fairness. Is it fair for a CPA firm to be held legally liable when client management knowingly deceives the auditor about a financial matter and then takes steps to cover its tracks?

On the other hand, is it fair to the client to have such limitations on CPAs' liabilities if, for example, a rogue employee caused the fraud and, as alleged by the client, the CPAs should have discovered it through their audit procedures?

There is no simple answer to the fairness issue because it depends on the underlying circumstances. CPAs who seek to limit their liability to clients when management fraud leads to materially misstated financial statements seek to hold management legally liable for its own fraud.

Responsibility and accountability are integral elements in ethical behavior.

From a utilitarian perspective, the CPA could easily justify using indemnification clauses because the costs to them are negligible while the benefits of not being financially responsible for management fraud are substantial. From a practical perspective, it may not be so easy to determine where management fraud begins and audit insufficiencies start.

Another aspect of this issue is that audit engagement agreements between a company and its auditor aren't public documents. As a result, some investors are pushing companies to spell out these provisions and make their implications crystal clear.

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76)The attorney probably believes the allegations may create a strong inference that the CFO acted with the required state of mind, or scienter, which is a mental state that reflects a defendant's intent to deceive, manipulate, or defraud. Scienter is a required element of a private securities fraud claim.

The Private Securities Litigation Reform Act strengthened the pleading standards for fraud cases by requiring the plaintiff to state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind. The courts look at whether the defendant's motive and opportunity to commit fraud reflect evidence of conscious misbehavior or recklessness.

A legal principle that makes officers, directors, managers, and other agents of a corporation immune from liability is when their decisions are made in good faith. Under the business judgment rule, the officers and directors of a corporation are immune from liability to the corporation for losses incurred in corporate transactions within their authority, so long as the transactions are made in good faith and with reasonable skill and prudence.

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77)a. A client has a privity relationship with the auditor, which makes the auditor liable for fraud, gross negligence, and ordinary negligence.

To recover losses under common law, a client must prove losses, reliance on the auditors' representations, that the reliance was proximate cause of the losses, and negligence on the part of the auditors. b. A third party is not in a contractual relationship with the auditor. The auditor has a liability for fraud and gross negligence but it is not completely clear that the auditor would be liable to the client for ordinary negligence. Common law decisions establish legal standards for liability in that regard.

Generally, to recover losses under common law, ordinary third parties must prove losses, reliance on the auditors' report, that the reliance was proximate cause of the losses, and gross negligence on the part of the auditors. Courts may also require demonstrating a direct link between the auditor and third party and that the third party was not negligent in using the audited information for decision making. c. The student may use rights, deontology, utilitarianism, or virtue theories to argue that if the auditor does his job, meeting all duties and obligations, then the law and ethical obligations are in alignment. For example, the diligent auditor demonstrates objectivity, due care and professional skepticism, and virtues that are critical to conducting an audit in accordance with GAAS. An auditor that places his obligation to third parties, such as creditors, ahead of that to the client, is meeting his public interest responsibility. Investors and creditors have a right to receive accurate and reliable financial report information. Auditors should act in a way they would want other auditors to act in similar situations for similar reasons so that their actions have universal appeal and would be acceptable to a broad group of accounting professionals.

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rules should never be violated including knowingly providing false information to a third party.

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78)The payments of $100–$500 to expedite off-loading of the goods are facilitating payments because they are made to expedite a process, but one that should occur as a normal course of business except for the payment. It is common in many countries to have to "grease the wheels" to get things done that should be done anyway because it is part of the acting officials routine duties.

The sponsoring of guests from state-owned enterprises to attend the Olympics in China are bribe payments to win lucrative contracts to be awarded to Chinese businesses as a return favor. It is a "quid pro quo," or something that is given to someone or done for someone in return for something given to or done for someone else. The covering of expenses for the guests is a payment to be awarded the future contracts so they are made to induce a behavior that otherwise should not necessarily be done until and unless a competitive bidding process is allowed to play out.

Facilitating payments involve a set of questionable behaviors because: ● The custom official has an incentive not to carry out her duties of resolving the issues entrusted to her as swiftly or as efficiently as is to be expected of a conscientious public servant. ● The Chinese companies are entitled to the service, and to have it delivered on a timely basis. ● The official may ask for larger and larger payments over time especially if foreign suppliers agree to make these payments readily. ● Facilitating payments may represent a step towards a culture of corruption in society above all if instances of easy wealth, legal impunity, and willingness to break the law proliferate. ● The Chinese companies may take the initiative to offer other officials facilitating payments believing it is part of the cost of doing business in these countries even if such payments are not requested. ● Facilitating payments lead to inefficiencies in the providing of services to Chinese and other companies that play the game.

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● Shareholders are not aware of the payments generally speaking and probably would not approve of the use of the company's resources in that way. ● If the use of facilitating payments becomes common practice, they have a corrosive effect on people's trust in legal, administrative, and judicial procedures.

Ethical legalism is at play in this case. Facilitating payments are legal but not very ethical. Just imagine if every company had to make such payments to get things done (They do in some countries). The level playing field for multinationals is lost unless every company makes the payments and then the requested payments would likely increase in amount. It becomes a snowball effect and once a company agrees to such payments, it has begun the slide down the ethical slippery slope.

Facilitating payments have a pernicious effect on the working of the requesting government administration because all too often they are the slippery slope to more serious forms of corruption. They impose additional costs on companies and citizens and in the long run threaten the ethical foundations of organizations.

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79)In FCPA enforcement, cultural norms are irrelevant. It does not matter to law enforcement whether corrupt acts—like paying "commissions" to sales agents in Brazil making small payments to regulatory officials in Turkey—are standard practice in a certain country.

It is true that the FCPA provides an affirmative defense for activity that is lawful under written local laws or regulations. But we know of no written local laws that legalize bribery, even petty corruption. However, arguments are sometimes made in favor of making exceptions to antibribery rules based on local culture. Consider the following rationalizations for facilitating payments and/or bribes.

1. "In cultures where bribery is accepted, it is justified." This argument implies that some cultures are inherently more corrupt than others. Not surprisingly, this view is frequently offensive to people from the "more corrupt" cultures, and the argument is further weakened by the difficulty of measuring and defining corruption.

The view also suggests that tolerating bribery equates to implicit approval or acceptance by a country's people. If you were to ask people on the streets of Rio de Janeiro, Brazil or Lagos, Nigeria if they approve of officials who accept bribes, you would get few, if any, "yeses".

People in countries with high corruption understand the personal impact of procurement officials who select low quality goods like poorly constructed roads and bridges in exchange for kickbacks.

2. "In some countries, bribery is built into the economy." In other words,

the system itself expects bribery. The tax collector must demand bribes because she is not paid enough to live on. But, even considering these human dimensions, corruption is still criminal. The plight of low-level officials highlights not the need for more bribes but the need for improved state systems. If a company wants to change such systems to improve the business environment, there are ways to do this short of Version 1

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bribery.

3. "Bribes make an economy more efficient." Some argue that bribes make economies work better by, for example, streamlining bureaucracies. But, in practice, the opposite is generally true. When corruption is tolerated, bureaucrats have an incentive to create more choke points from which they can extract even more benefits.

4. "These are not bribes, they are something else." One of the trickiest areas for FCPA compliance is determining when a gift, entertainment, or something else of value that is acceptable in one culture is actually a bribe under the FCPA. What if business people would regularly take high-ranking public officials to expensive dinners and say that is the way things are done. But is it legal?

Complicated matters like these must be decided on a case-to-case basis with the participation and judgment of a compliance officer, attorney, and other qualified management. They should be decided with careful consideration of the company's own compliance program, acceptable standards in the industry, and law enforcement's guidance in previous actions, opinion releases, public statements, and other sources of authority.

Geert Hofstede's studies of cultural values were discussed in Chapter 1.

Originally, Hofstede was able to draw out four dimensions of culture, which included: power distance, uncertainty avoidance, individualism, and masculinity. He later added a fifth—long-term orientation.

Power distance was thought to capture the extent to which there was equality in power between members in society. For example, in a society where there is great power distance, many individuals accept the authority and have no say in decisions that are made. With respect to facilitating payments, a society with a high score on power distance might tolerate such payments because of the strong authority position of the central government. A low score on individualism implies a society Version 1

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run for the collective good with loyalty to the group, citizenry and government. Here, facilitating payments are more likely to be accepted by society in order to "go along to get along." The same result would occur with a high score on uncertainty avoidance as people in that kind of society do not want to rock the boat. If a person has weak uncertainty avoidance then they will be content with letting things happen as they may.

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80)A company's CEO and CFO must each provide two certifications as part of the company's quarterly Form 10-Q and annual Form 10-K. The certifications are required under Sections 302 and 906 of the SOX. The certifications are executed individually and filed as exhibits to the applicable quarterly and annual filings. Although certifications are not included in reports other than Forms 10-Q and 10-K, the disclosure controls and procedures to which the CEO and CFO certify must ensure full and timely disclosure in all current reports, as well as definitive proxy materials and definitive information statements.

Under Section 302, the CEO and CFO make statements related to the accuracy of the reports filed with the SEC and the controls and procedures established by the company to ensure the accuracy of such reports. The certification must be in the exact form set forth in the rule, and the wording may not be changed in any respect whatsoever. The CEO and CFO must each certify that: ● She has reviewed the report; ● Based on her knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances, not misleading; ● Based on her knowledge, the financial statements and financial information fairly present, in all material respects, the company's financial condition, results of operations and cash flows of the company; ● The certifying officer(s) is/are responsible for: ● establishing and maintaining disclosure controls and procedures; ● having designed such disclosure controls and procedures to ensure that they are informed of all material information; ● having each evaluated the effectiveness of the disclosure and financial controls and procedures as of the end of each period in which they are making the certification; and Version 1

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● having disclosed their conclusions regarding the effectiveness of the controls and procedures in the subject Form 10-Q or 10-K; ● She has disclosed to the company auditors and to the audit committee any significant deficiencies or material weaknesses in the design or operation of internal controls over financial reporting which could adversely affect the company's ability to record, process, summarize, and report financial data; ● She has disclosed to the company auditors and to the audit committee any fraud, material or not, that involves employees who have a significant role in internal controls over financial reporting; and ● She has disclosed any changes in the internal controls or financial reporting in the subject Form 10-Q or 10-K, including changes designed to correct deficiencies or material weaknesses.

If a material weakness is uncovered, it must be disclosed in a Form 10-K and, as a result, management cannot conclude that its controls and procedures are effective. The SEC defines a material weakness to be a deficiency, or a combination of deficiencies, in internal control over financial reporting that creates a reasonable possibility that a material misstatement of a company's annual or interim financial statements will not be prevented or detected on a timely basis. The disclosure of a material weakness should include the nature of the weakness, its impact on financial reports and plans or steps and changes made to correct the disclosed material weakness.

Section 302 does not specify methods or procedures that should be used for effective internal controls and procedures. Rather, the SEC encourages CEO's and CFO's to develop systems that best fit the facts and circumstances of their particular enterprises. However, the SEC has given some guidance, encouraging that management (1) develop and continually test its procedures and their effectiveness; (2) document evaluation in writing, including methods used to test and evaluate Version 1

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procedures and the conclusions and results; (3) keep good records and documentation; and (4) rely on outside auditors and advisors to provide input.

In order to ensure that the CEO and CFO certifications are accurate and can properly be executed, a company must establish the underlying procedures to which the CEO and CFO evaluate and attest. The controls and procedures must be designed to address both quality and timeliness of disclosure. Unlike pre-existing concepts of internal controls over financial reporting, the SOX certifications include required material nonfinancial information, as well as financial information.

The SEC has identified the Treadway Commission Committee of Sponsoring Organizations report and framework on internal controls as an acceptable system and accordingly, it is almost uniformly used and relied upon. The Treadway Commission has published a separate report directed toward internal control systems for smaller public companies.

The report noted that smaller companies' management tends to have a hands-on approach, wider spans of control and the ability to provide ongoing monitoring through direct relationships with key personnel, customers, vendors and capital providers that, along with in-depth knowledge of operations, processes, contractual commitments and business risks, can create opportunities for controls to be effective while being less formal. Managers in smaller public companies are more directly involved with the company's controls on a daily basis.

In general, as signors of such reports, the CEO/CFO can be liable for material misstatements or omissions under general antifraud standards and under the SEC authority to pursue actions against those who cause or aid or abet securities law violations. An officer providing a false certification potentially could be subject to SEC action for violating Section 13(a) or 15(d) of the Exchange Act and to both the SEC and private actions for violating Section 10(b) of the Exchange Act and Version 1

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Exchange Act Rule 10b-5.

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81)There are many examples where auditors violated independence expectations. In 2015, Deloitte & Touche LLP agreed to pay over $1 million to settle charges related to independence violations resulting from a business relationship with a trustee serving on boards and audit committees of three funds that the company audited. In 2016, the SEC announced that E&Y agreed to pay 9.3 million to settle charges that three audit partners engaged in relationships that created familiarity threats to independence when audit partners socialized with executives that they audited.

A number of additional situations can cause an actual breach of independence, or—just as serious—the appearance of such a breach.

These include the following: 1. Employment relationships. AICPA and SEC independence rules both provide that an audit firm's independence will be impaired if former firm professionals are subsequently employed by or associated with an attest client in a key position, unless certain conditions are met. In addition, the SEC rules, being the more restrictive, include shareholders as covered members and require a one year cooling-off period before a company can hire an individual formerly employed by its auditor for a position involving oversight of the financial reporting process at the registrant entity.

2. Direct or material indirect financial interests. The AICPA and SEC independence rules both explicitly state that a member or a member's firm may not have or be committed to acquire any direct or material indirect financial interests in a client. Further, both the AICPA and SEC independence rules provide similar, but not identical, language regarding guidance on situations in which serving as a trustee or executor of an estate that has a direct or material indirect financial interest in the client will impair independence.

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or from clients, without regard to materiality, impair independence (unless the loan is from a financial institution and certain criteria are met).

4. Business relationships. AICPA and SEC independence rules provide that business relationships with clients—such as joint ventures, limited partnership agreements, investments in supplier or customer companies, and sales by the member of items other than professional services—will impair independence. AICPA rules regarding business relationships with clients provide that if a member or a member's firm has a material joint, closely held business investment with a client, independence is impaired.

A joint closely held business investment refers to an investment that is subject to the control of the member or the member's firm, the client, the client's officers, directors or principal stockholders or any combination thereof. The AICPA rules address such situations as creating a threat to independence that must be mitigated by specific safeguards to avoid violating the independence rules.

The foregoing are certainly not the only instances in which auditor independence could be lost or threatened. Importantly, since the appearance of independence must be maintained, various permutations of these fact patterns, even if not expressly addressed by SEC or AICPA rules, could give rise to allegations of breaches making auditors vulnerable to assertions of malpractice.

As further scrutiny is placed on auditor independence, in both fact and appearance, it is probable that auditor liability due to violations of auditor independence will remain an area ripe for litigation.

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