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
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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 Nation
Occupational 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
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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
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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
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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)
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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)
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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
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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
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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
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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:
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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