Chapter 3

Creating Ethical Organization Environment and Effective Corporate

Governance Systems

Questions for Consideration

1. How does organization culture influence ethical decision making?

2. When should an employee consider blowing the whistle on wrongdoing?

3. Would you have agreed to launch the Challenger just to go along with management at NASA?

Seven Signs of Ethical Collapse

“Occurs when any organization has drifted from the basic principles of right and wrong”

• (1) Pressure to maintain numbers• (2) Fear and silence• (3) Young ‘uns and bigger than life CEO• (4) Weak board of directors• (5) conflicts of interests overlooked or unaddressed• (6) Innovation like no other company• (7) Goodness in some areas atones for evil in others

Pressure to Maintain Numbers and Fear of Reprisals

• Ethical collapse occurs when there is an unreasonable and unrealistic obsession with meeting quantitative goals– “financial results at all costs”

• Employees are reluctant to raise issues of ethical concern because they may be ignored, treated badly, transferred or worse – “kill the messenger syndrome”

Loyalty to the Boss and Weak Board of Directors

• Young people selected by the CEO for their position based on inexperience, possible conflicts of interest, and unlikelihood to question the boss' decisions

• Weak board of directors characterizes virtually all of the companies with major accounting frauds in the early part of the 2000s

Culture of Conflicting Interests

• Good example: dual relationship between investment bankers and financial analysts

• This conflict of interest arises because the investment bank serves two client groups- the firms for which it issues securities and the investors to whom it sells these securities

Innovation and Ethics and Community Involvement and Ethics

• Some CEO’s believe the same rules don’t apply because their company is so different and more innovative than others

• Remedies for good/evil balancing act include rethinking the popular notions of social responsibility and business and rethinking company activities, perceptions, and realities – ‘Doing well by doing good’– Rely on virtues: truth, honesty, fairness, and

egalitarianism

Organizational Influence on Ethical Decision Making

• The Jones-Hiltebeitel model looks at the role of one’s personal code of conduct in ethical behavior within an organization – Moral intensity

• When one’s personal code is insufficient to make the necessary moral decision, the individual will look at professional and organizational influences to resolve the conflict

Ethical Dissonance Model

• Interaction between the individual and the organization, based upon person-organization ethical fit at various stages of the contractual relationship in each potential ethical fit scenario

• Four potential fit options: – 1: high-high (high organization & high individual ethics)– 2: low-low (low organization & low individual ethics) – 3: high-low (high organization & low individual ethics)– 4: low-high (low organization & high individual ethics)

What is Business Ethics

• Comprise the principles, values, and standards that guide behavior in the world of business.– Principles are specific and pervasive boundaries for

behavior that are universal and absolute– Values are beliefs that guide behavior and support the

overall organization vision; they provide a frame of reference

– Not one consistent set of standards that all companies follow; the ethical standards for the accounting profession are embodied in its codes of conduct

The IIA’s Code of Ethics

• Principles:– Integrity– Objectivity– Confidentiality– Competency

• These are very similar to the AICPA’s and IMA’s. Integrity, objectivity, and competency are included in all three codes.

Business Ethics vs. Personal Ethics

John Maxwell believes there is no difference, should follow the Golden Rule all the time and ask, “ How would I like to be treated in a particular situation?”

• Many people seem to have different ethics in the workplace than in the home

• Trust in business is the cornerstone of relationships with customers, suppliers, employees and others who have dealings with an organization

Johnson & Johnson: A Case of Dr. Jekyll and Mr. Hyde?

• J&J’s credo emphasizes primary obligation to those who use and rely on the safety of its products

• Tylenol Poisoning – J&J put customer safety first• J&J has been withdrawing from its “trust” bank in recent

years– Illegally promoted the antipsychotic Risperdal– Misleading statements about the recall of Motrin– Included methylene chloride, which is banned by the FDA, in

their baby shampoo– Ethicon vaginal mesh did not meet reasonable safety standards

• Takes a long time to build a reputation of trust, but not long at all to tear it down

2011 National Business Ethics Survey

• Views of Employees from 2007-2011:– Percentage of employees who witnessed wrongdoing declined over

the 5 years by 10% and those reporting misconduct increased 7%. – Pressure to compromise ethical standards increased along with

retaliation against whistleblowers doubled• Five most recent types of misconduct: (1)misuse of company

time, (2)abusive behavior, (3)company resource abuse, (4)lying to employees, and (5)violating internet policies

• Stakeholder management requires that an individual consider issues from a variety of perspectives other than one’s own or that of the organization

The Ford Pinto Case• Subcompact car• Unsafe gas tanks could burst into flames • Initial ethical legalism• Risk/cost benefit analysis • Too costly to replace the fuel tanks• Compliance with law versus ethical behavior• Utilitarian reasoning– Focusing on costs and benefits– Ignores rights of various stakeholders– Omitted important factor

ACFE 2012 Report to the NationOccupational Fraud

• Fraud can be defined as a deliberate misrepresentation to gain advantage over another party

• Typical business loses 5% of annual revenues to fraud; median loss of $140,000

• Occupational fraud is use of one’s occupation to misappropriate organization’s resources or assets for personal gain

• Frauds lasted a median of 18 months before detection• More likely to be detected by tip than any other way• Asset misappropriation schemes was most common type of

occupational fraud• Larger losses from higher position or longer tenure individual

Behavioral Indicators of Fraud

• Living Beyond Means• Financial Difficulties• Unusual Close Association with Vendor/Client• Control Issues, Unwillingness to Share Duties• Divorce/Family Issues• Wheeler-Dealer Attitudes• Instability, Suspiciousness or Defensiveness• Addiction Problems

Financial Statement Fraud

Fraud schemes occur because an employee – usually top management – causes a misstatement or omission of material information in the organizations’ financial reports.

Methods include:• Revenue Overstatement• Expenses Understatement• Improper Asset Valuations

Miniscribe Fraud

• Top management committed the fraud and overrode internal controls

• Company lacked independent members on its Board of Directors

• Salaries and bonuses often depended on Miniscribe “making the numbers”

• Inventory hole initially worth $2-4 million, then $15 million• Miniscribe bought bricks to disguise as hard drives and

conceal as inventory worth $4 million• Repeatedly signed management letter stating financial

reports were accurate and truthful

Corporate Governance Systems

• Corporate governance systems establish control mechanisms to ensure organizational values guide decision-making and ethical standards are being followed. Characteristics include: – Accountability – Oversight, and – Control

• Corporate governance can be seen as a set of rules that define the relationship between stakeholders, management, and board of directors of a company and influence how that company is operating

Agency Theory, Problem, and Costs• Agency Theory

– Corporate managers and directors are agents– Shareholders are the principal– Construct rules and incentives to align the behavior of agents with

the desires of the principals• Agency Problem

– Desires and goals of agents and principals may not be in accord– Difficult to verify the activities of the agents

• Agency Costs– Agents likely to place personal goals ahead of corporate goals– Results in conflict of interests between agents and principals– Consistent with egoism– Information asymmetry– Occurs if BOD fails to exercise due care in oversight

Overcoming Agency Problem

• Executive compensation• Controlling management through Board of

Directors’ actions• Accounting system as a monitoring device– Internal control– Disclosure

• Audited financial statements• Stewardship Theory and other theories

Corporate Governance• Definition of Corporate Governance

– Set of rules that define the relationships between• Stakeholders• Management• Board of Directors

– Influence how the company is operating– Issues of separation of ownership and control

• Importance of Good Governance– Better access to capital– Aids economic growth– Positive impact on stock prices– Ensures that business is fair and transparent – Ensures that companies can be held accountable– Leads to sustainability– Consequences of Weak Governance

Executive Compensation• Link managerial compensation

– Financial performance of company in general– Stock price performance– Maximize stock price

• Problems– Manipulation of earnings– Ratio of U.S. CEO to lowest employee salary (344 to 1)– Backdating of stock options

• Sarbanes Oxley Act gave ability to clawback compensation and stock profits of CEOs and CFOs in financial restatements caused by misconduct

• Dodd Frank Wall Street Reform and Consumer Protection Act changed executive compensation and whistle blowing procedures; “say on pay”

Governance Mechanisms• Internal (help manage, direct, and monitor corporate governance activities to

create sustainable stakeholder value)– Independent directors– Audit committee– Management– Internal controls– Internal audit

• External (intended to monitor the company’s activities, affairs, and performance to ensure that the interests of insiders) – Financial markets– State and federal laws and regulations– Court decisions– Shareholder proposals

• Most important mechanisms– Independent directors– Separate meetings between audit committee and external auditors

Role of BOD and Officers• BOD has ultimate responsibility for success or failure of

company• Principles must be part of the culture

– Ethical and honest behavior– Compliance with laws and regulations– Effective management of resources and risks– Accountability of personnel

• Establish ethical culture and code of conduct• Communicate these principles within organization• Board members have fiduciary duty to safeguard assets and

and make decisions that promote shareholder interest• Business Judgment Rule – managers and BOD immune from

liability so long as decisions made in good faith and with reasonable skill and prudence

Audit Committee

• Independent directors• Oversight of financial reporting

– Internal audit function– External auditors

• SOX mandated – independence; financial expertise• Listing requirement of NYSE• Seen as the one body that should be able to prevent

identified fraudulent financial reporting• Committee should meet separately with the senior

executives, the internal auditors, and the external auditors

Best Practices of Audit Committees

1. Focus on financial reporting and strong internal controls 2. Review the company's whistleblower processes and

compliance program 3. Understand the significance of risks to the company's

operations and financial reporting 4. Consider whether the company's disclosures provide investors

with the information needed to understand the state of the business

5. Set clear expectations for the internal audit function and communication with the external auditors

6. Understand the audit committee's role in information technology

Internal Controls

• Prevent and detect errors and fraud– Asset misappropriations– Materially false and misleading financial reports– Inadequate disclosures

• Ensure management policies are followed• Ethical systems built into corporate governance• Can be overridden by top management– Do what CEO says, not what he does– Creates cynical attitude

COSO Internal Control – Integrated Framework

• Emphasizes roles of BOD, management and personnel• Designed to provide reasonable assurance

– Effectiveness and efficiency of operations– Reliability of financial reporting– Compliance with laws and regulations

• Framework– Control environment– Risk assessment– Control activities– Monitoring– Information and communication

• Groupon example of internal control failure: had to restate financial statements because of material weakness in internal control’s; management caught internal control, not auditors

NYSE Listing Requirements

• A majority of independent directors• Non-management directors must meet at regularly

scheduled executive sessions without management• Audit committee with minimum of 3 independent

members • Audit committee must meet separately with

management, internal auditors, and independent auditors• Audit committee should review with the independent

auditor any audit problems or difficulties and management’s response

NYSE Listing Requirements (cont)

• Audit committee should report regularly to the BOD • Must have internal audit function• CEO must certify to the NYSE each year they are not

aware of any violation of NYSE standards • Must adopt and disclose corporate governance

guidelines • Foreign private issuers must disclose any significant

ways in which their corporate governance practices differ from those followed by domestic companies

Newly Amended Corporate Governance Listing Standards

• Enhanced notification requirements• Communications with directors• Disclosure of business conduct and ethic

waivers• Executive sessions

Codes of Ethics for CEOs and CFOs

• Certifications that financial statements have no material misstatements

• Separate code from company’s code of ethics• SOX requirement– Whether companies have codes of ethics

• General• Separate code for senior (financial) management

– Waivers on the code of ethics for senior management– Any changes to the code of ethics– If no code, must explain why

Compliance Function

• Ethics and Compliance Officer Association (ECOA) has increased responsibilities resulting from SOX

• ECOA promotes ethical business practices• Trusted member of management should be

organization’s ethics leader; create a positive ethical tone

• Chief compliance officer should see if new ideas pass the ethics “smell” test

Bernie Madoff’s Ponzi Scheme• Returns to one set of investors from funds of subsequent

investors; schemes require a consistent flow of new money• $65 billion fraud• Madoff sentenced to 150 year prison term• $170 million to be returned to victims • “Clawback” lawsuits to recover some of the money • Madoff’s Auditors, Friehling & Horowitz:

– Did not perform anything remotely resembling an audit– Did not perform procedures to confirm securities– Failed to document findings and conclusions on limited

procedures, as required by GAAS– Did not test internal controls– Was not independent

Moral Hazards and the Financial Crisis

• Excessive risk taking and mortgage meltdown• “Moral hazard” as contributing factor• Corporate governance failings

– Breach of fiduciary duty– Gross negligence– Unjust enrichment for insurance claims

• Improper practices– High risk lending strategy– Shoddy lending practices– Steering borrowers to high risk loans– Polluting the financial system– Securitizing delinquency-prone and fraudulent loans– Destructive compensation

• Federal False Claims Act & Whistleblowing

Blame And Prevention• Blame – Madoff Fraud

– Bernie Madoff used his reputation to gain favor with investors– Auditor – Friehling & Horowitz– SEC – failed to act on tips 8 years before failure from external

whistleblower• Concerns over watchdog ability

• Prevention Measures– Surprise exam by independent CPA of all investment advisers

who have control or custody of clients’ assets– Third party written report assessing the safeguards protecting

clients’ assets– Advocating reward to whistleblowers and demanding no

retaliation against them

Whistleblowing

• Employees (former or current) who report suspected violations

• Four elements: – The whistleblower – The whistleblowing act – The party to whom the complaint is made – The organization involved with the complaint

• “Bystander effect” • Whistleblower laws protects employees who provide

information on a fraud and from retaliation• R. Allen Stanford ponzi scheme, whistleblower was ignored

Dodd-Frank Wall Street Reform and Consumer Protection Act

• 2010 passage of this increased benefits for whistleblowers who aid in recovery of $1M or more, can receive 10-30% of the amount

• Concern: Will whistleblowers go straight to external sources instead of internal?

• Protection from being fired; including reinstatement, double back pay, and special damages

• Whistleblowers who only report internally may not be protected• Also encourages accountants and auditors to report wrong doing• Public accounting industry worried about client confidentiality• Incentive provision ethical?

Accountants’ Obligations for Whistleblowing

• Dodd-Frank contains provisions to encourage accountants and auditors to report corporate wrongdoing

• Excludes two categories of accountants– Individuals with internal compliance or audit responsibilities

at an entity– CPAs who acquire knowledge of potential violations through

an audit required by federal securities laws• CPAs may report information about potential violations

about own firms’ performance of audit services of client