ACCT Ethics Paper 1 - Grade: A+ PDF

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Analysis of ethical case from week 1 with documented sources from accounting research online resources...

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Diana Medlock Accounting Ethics – Paper 1 The Phar-Mor case includes misstatement of revenues to the tune of over $500 million. This took place over a five-year period and was facilitated through a series of false records, journal entries, and inflated inventory counts. Multiple members of senior management were involved in and helped to cover up the fraud. This case presents multiple ethical and accounting issues. Stakeholders in the Phar-Mor case include the management, employees, vendors, external auditors, and the public interest of investors and creditors. Management is unique in that they are ultimately representatives of the company and responsible for balancing the precarious relationships among all other stakeholders, but as individuals, members of management are stakeholders similar with interests similar to that of all other employees. In this case, fraud is carried out by employees that are directed by management. Employees have an interest in the success of the company because they presumably wold like to maintain their employment and quality of life. The external auditors, Coopers & Lybrand, indirectly contributed to the fraud by providing advance warning of inventory counts and by observing the inventory levels at a relatively small sampling of stores, 4 out of over 300. Additionally, in legal proceedings following the discovery of the fraud, Coopers & Lybrand were found guilty of fraud through reckless issuances of audit opinions, ultimately a lack of “due care”. Vendors are also stakeholders, as they directly contribute to and are impacted by the operations of the company. Many vendors were close to or had already discontinued shipments of products to Phar-Mor as payables were increasingly stretched as the result of a cash shortage. Investors and creditors are directly impacted by the Company’s operations and the representations of its financial performance as included in financial statements. At the time of bankruptcy, Phar-Mor had 38+ lenders and creditors. Ethical responsibilities include the accounting profession’s obligation to uphold the public trust by providing accurate and timely information as represented in the financial statements. This stems from the multiple conflicts of interests a CPA faces every day in the profession. As noted above, each of the accounting professionals involved in the Phar-Mor fraud was also a stakeholder of the Company and therefore impacted by its operations, more specifically the financial success of the firm. This conflicted with their duty as CPAs to observe and report all material information that could affect an investor or lenders decision to provide capital or financing. Multiple members of the Phar-Mor staff were previously

Diana Medlock Accounting Ethics – Paper 1 auditors and Coopers & Lybrand and they showed blatant disregard for the importance of accurate representation of financial performance. “They knew that Coopers traditionally did not review zerobalance accounts, so by parking erroneous amounts in the bucket accounts, then allocating the balances of those accounts to inventory at year end, they were successful.” (Lansing, The Case of Phar-Mor Inc.) Accounting issues include the overstatement of inventory through a variety of methods that resulted in a material misstatement in the financial performance of the company. Multiple creditors and investors provided capital and credit facilities to Phar-Mor based on this information, and this was the first of multiple corporate fraud scandals that resulted in widespread investor distrust of the accounting profession and the quality of financial statements.

In his article, Ghost Goods: How to Spot Phantom Inventory, author Joseph Wells highlights the prevalence of inventory-overstatement-related fraud and discusses multiple red flags that could alert an auditor to various types of inventory fraud. “In a 1999 study, the Committee of Sponsoring Organizations of the Treadway Commission found misstated asset valuations accounted for nearly half the cases of fraudulent financial statements. Inventory overstatements made up the majority of asset valuation frauds” (Wells, Ghost Goods: How to Spot Phantom Inventory). Auditors should take a more rigorous approach to observing inventory, included un-announced inventory counts or a wider sampling of inventory locations. Auditors should begin the inventory audit process by engaging employees in informal interviews and asking them whether anyone has asked them to misstate or inflate inventory values. This should be done in a non-accusatory way. This can prevent the physical movement of inventory to previously disclosed locations in order to boost inventory count. Wells also reminds auditors to complete analytical procedures based on historical trends and changes in financial statement ratios over time. Key considerations include: inventory growth that exceeds sales growth, decreasing inventory turnover, decreased shipping expenses as a percentage of inventory, growth in inventory as a percentage of total assets, improvements in gross margin, and discrepancies between cost of goods sold on the books versus what is included in tax returns. Additionally, an auditor’s review of the Company’s cash disbursements following the end of a reporting period can uncover payments made directly to vendors but not recorded.

Diana Medlock Accounting Ethics – Paper 1 As management assessed the conflicts of interest facing them, it’s understandable that some people felt compelled to cover up the fraud. Cherelstein, the controller, said that he didn’t disclose the fraud because he feared for his personal health. Others communicated that they depended on the income and needed to take care of their families. However, there is not much research on the “ethical dilemmas” in this case. This fact leads me to believe that this is primarily a legal issue. A dilemma is caused by a gray area that could be interpreted as being in favor of both sides of an argument. It requires prioritization of ethical responsibilities and duties to others. There is not a dilemma in this situation; there is no compelling argument to be made for materially misstating financial statements for multiple years. There are reasons and rationalizations including that the original inventory inflation was a “one-time event” or that in later years, it was “standard practice” but neither of these reasons are supported by any moral or virtue which would cause a dilemma. There is no issue in prioritizing moral virtues; it is either to be honest and transparent or dishonest and purposely deceitful. Furthermore, if we are to utilize Kant’s categorical imperative to assess the situation, this results in a contradiction in conception: if all people were to falsify their financial statements, which are in essence a true and accurate representation of the company’s financial performance at a point or over a period of time, then there would be no true and accurate representation of financial performance. If all people told lies, there would be no concept of truth. This sounds like an opinion, but is well substantiated by research or lack thereof on the ethical dilemmas in this case. There are cut and dry accounting issues, as noted previously.

Regulation is required within a capitalist society when members of society prove that they are not able to be compassionate beings, as required under Smith’s definition of capitalism. These regulations simulate compassion when we prove that given a choice, we repeatedly choose not to display compassion. Smith argues that we are self-interested and driven to make decisions for our benefit, but that we are also compassionate, which enables us to self-regulate rather than requiring pro-active regulation that occurs in socialist societies. The accounting profession and its members demonstrated multiple times that they would act in self-interest or for self-gain rather than respecting the rights of other stakeholders and their right to quality financial information. This violation of the stakeholders’ rationality shifts responsibility for the consequences of this situation from the stakeholders back to the accounting

Diana Medlock Accounting Ethics – Paper 1 firm and management. Responsibility for consequences requires two things: autonomy and rationality. Withholding the information about Phar-Mor’s true financial performance violates external parties rationality and their ability to make a well-informed decision. There is a power imbalance between the preparer and user of financial statements as a result of the specialized knowledge required of CPAs in order to perform audit functions. It follows that laws have been enacted to address this imbalance, requiring both management and auditors to attest that they accept responsibility for the validity of information presented in financial statements.

The Sarbanes-Oxley Act of 2002 establishes the senior management’s responsibility for reviewing all financial reports and signing to certify that reports fairly present in all material aspects the financial condition and result sof operations of the issuer. Furthermore, officers are responsible for establishing and maintaining internal controls and that any significant deficiencies in the design or operation of internal controls have been disclosed. Officers must also disclose any fraud, whether or not material, that involves management or other employees who have a significant role in the issuer's internal controls. This regulation requires a code of ethics for senior financial officers that support the full, fair, accurate, timely, and understandable disclosure in the periodic reports required to be filed by the issuer. (Lansing, The Case of Phar-Mor Inc.)

In summary, there are many ways the auditing firm of Phar-Mor could have exhibited a higher level of professional skepticism. Ethical responsibilities of both management and the external audit team were not upheld, and as a result the public trust was violated. Court decisions uphold the argument that the material misstatements included in the financial statements violated the rationality of the end users of these statements and as a result, both management and the auditing firm paid millions in fines or served jail time. Reactive regulation was imposed in order to address the power imbalance that exists between CPAs and end users of financial statements.

Diana Medlock Accounting Ethics – Paper 1

Sources:

Cottrell, D. M., & Glover, S. M. (1997). Finding auditors liable for fraud. The CPA Journal, 67(7), 14-21. Retrieved from https://login.libweb.lib.utsa.edu/login? url=http://search.proquest.com.libweb.lib.utsa.edu/docview/212271657?accountid=7122

Wells, Joseph T. (2001) Ghost Goods: How to spot phantom inventory. Journal of Accountancy. Online Resource. Retrieved from http://www.journalofaccountancy.com/issues/2001/jun/ghostgoodshowtospotphantominventory.html

Williams, S. L. (2011). The case of phar-mor inc. The CPA Journal, 81(9), 58-63. Retrieved from https://login.libweb.lib.utsa.edu/login? url=http://search.proquest.com.libweb.lib.utsa.edu/docview/900320464?accountid=7122...