ACCT019 - Ethics Chapter 3 PDF

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Chapter 3 Organizational Ethics and Corporate Goverance...

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Organizational Ethics and Corporate Governance Chapter 3  

This chapter starts out by talking about the Wells Fargo ethics failure and the lessons learned from it. Then reminds us that a critical component of creating an ethical organization environment is the culture that includes shared values, beliefs, goals, norms, and problem-solving mechanisms.

Organizational Ethics, Ethical Culture, and Ethical Climate Organizational Ethics are 

Generally accepted principles and standards that guide behavior in organizational contexts.

Ethical Culture is 

Explicit statement of values, beliefs and customs from top management and provides the framework for top management on how to manage themselves and employees

Organizational ethical climate is the   

Moral atmosphere and level of ethics practiced within a company Determined by leaders Focuses on issues of right and wrong.

Establishing an Ethical Culture 

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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 business. Tone at the top refers to the ethical environment that is created in the workplace by the organization’s leadership. Corporate culture starts with an explicit statement of values, beliefs, and customs from top management. A corporate 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.

*Ferral et al. describe a Framework for Understanding Ethical Decision Making in Business (Exhibit 3.1) Ethical Issue Intensity Reflects the importance of the issue to the individual, work group and/or organization (intensity) based on values, beliefs and norms involved and pressures in the workplace. Individual Factors  

Values of individuals are used in our daily lives to make decisions But organizational and social forces also play a role by shaping behavioral intentions and decision making

Organizational Factors Organization’s values often have a greater influence than a person’s own values. The more employees perceive an company’s culture to be ethical, the less likely they are to make unethical decisions Starts with  

Opportunity Conditions that limit or permit ethical or unethical behavior can be reduced with aggressive enforcement of rules and codes of ethics by the organization.

Business Ethics Intentions, Behavior, and Evaluations   

Organizational ethical culture is shaped by effective leadership We need a mechanism to evaluate pressures and respond to claims such as everyone does it. Here is were we rely on GVV (giving voice to values)

Organizational Influence on Ethical Decision Making 

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We are presented a model (Jones-Hiltebeitel) that looks at the role of one’s personal code of conduct in ethical behavior within an organization 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 Thus if an organization values profit above all else might result in a different course of action, such as go along with improper accounting

than an organization that values integrity above all else might lead to questioning the accounting. Seven Signs of Ethical Collapse In her book, Marianne Jennings analyzes the indicators of possible ethical collapse and how to avoid pending disaster. She believes this “Occurs when any organization has drifted from the basic principles of right and wrong” and identifies seven signs of moral meltdown in a company. 1. 2. 3. 4. 5. 6. 7.

Pressure to maintain numbers Fear and silence Young people (‘uns) and bigger than life CEO Weak board of directors Conflicts of interests overlooked or unaddressed Were so Innovative - like no other company Goodness in some areas atones for evil in others

The Sign of Pressure to Maintain Numbers and Fear of Reprisals 

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This first sign of 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 

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Young people selected by the CEO for their position based on inexperience, possible conflicts of interest, and unlikelihood to question the boss' decisions A weak board of directors characterizes virtually all of the companies with major accounting frauds in the early part of the 2000s There is a Culture of Conflicts- such as CEO is also the Chairman of the Board who sets the agenda for the board of directors. As chair of the board that person is also voting on his/her own compensation package.

Corporate Governance Structures and Relationships Corporate governance is shaped by internal and external mechanisms.

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Internal mechanisms help manage, direct, and monitor corporate activities to create sustainable stakeholder value. Examples: independent board of directors, the audit committee, management, internal controls and the internal audit function

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External mechanisms are intended to monitor the company’s activities, affairs, and performance to ensure that the interests of insiders (management, directors, and officers) are aligned with the interests of outsiders (shareholders and other stakeholders). Examples: the financial markets, state and federal statutes, court decisions, and shareholder proposals

Potential Agency Problems 

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There is a classic agency problem with public corporations wherein managers act as agents of the investors and who expect those decisions to increase the value of the stock they own. This problem has led to: Executive Compensation – compensation packages which are tied to firm’s performance and stock option plans creating an incentive to manipulate earnings - also emphasis short term view versus long term view Backdating stock options and improper disclosures The Dodd-Frank Protection Act brought in changes on this issue Allowed Clawbacks (recovery) which allow a recovery of compensation from CEOs and CFOs of public companies “Say on pay” provisions provide shareholders a vote regarding the compensation of CEO and CFOs

* Book talks about the Corporate Social Responsibility Example: The Ford Pinto Case    

st Ford’s 1 subcompact car Issue of unsafe gas tanks which could burst into flames – tank in rear not side of car Initial ethical legalism defense – but the company complied with all existing laws Risk/cost benefit analysis - The National Highway Safety Administration would excuse a defendant from being penalized if monetary costs of making changes were greater than the societal benefit

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Too costly to replace the fuel tanks ($137 million) butthis ignored potential cost of lawsuit judgements Compliance with law versus ethical behavior – Company met all safety requirements thus relied on act-utilitarian reasoning which ignores the rights of various stakeholders (stockholders and customers)

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

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J&J’s credo emphasizes primary obligation to those who use and rely on the safety of its products Tylenol Poisoning Issue– J&J put customer safety first But J&J has been withdrawing from its “trust” bank in recent years  Illegally promoted the antipsychotic Risperdal  Issue misleading statements about the recall of Motrin  Included methylene chloride, which is banned by the FDA, in their baby shampoo  DePuy Orthopaedics sold metal-on-metal hip implants that were found to shed minute particles into a patient’s bloodstream over time  Ethicon vaginal mesh did not meet reasonable safety standards Point being – it takes a long time to build a reputation of trust, but not very long at all to tear it down.

*Trust in Business   

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The Trust means to be reliable and carry through words with deeds. Trust becomes pervasive only if the organization’s values are followed and supported by top management. Trust can be lost, even if once gained in the eyes of the public, if an organization no longer follows the guiding principles that helped to create its reputation for trust. Credo is an aspirational statement that encourages employees to internalize the values of the company.

* The Ethical and Legal Responsibilities of Officers and Directors 

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Directors and officers of corporations are deemed fiduciaries of the corporation as their relationship with the corporation and its shareholders is one of trust and confidence. These duties include the: Standard of due car – act in good faith, exercise the care that an ordinarily prudent person would exercise in a similar situation

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Duty of Loyalty – act in the best interest of corporation and ahead of their personal interests; loyalty can be defined as faithfulness to one’s obligations and duties The Obligation of Good Faith – requires an honesty of purpose that leads to caring for the well-being of the constituents of the fiduciary. Business Judgment Rule – Directors are expected to exercise due care and to use their best judgment in guiding corporate management, but they are not insurers of business success; honest mistakes and poor business decisions do not make them liable to the corporation for resulting damages. Directors must be independent and disinterested at to the matter acted upon as well as acting with due care and good faith.

* The Best Practices of Governance require 

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Independent directors enhance governance accountability – public companies are required to have independent directors be a majority of the board Separation of the duties of CEO and board chair minimizes conflicts of interest Separate meetings between the audit committee and external auditors strengthen control mechanisms

Ethics in the Workplace A code of conduct goes beyond what is legal for an organization and provides guidelines for ethical conduct. Support for ethical behavior from top management is a critical component for fostering an ethical climate. Some measures that should be taken to establish an ethical culture:         

Clear policies on ethical conduct including a code of ethics Ethics training program that instills a commitment to act ethically and explains the code provisions A top level officer (Chief Ethics and Compliance Officer) to oversee ethics and compliance Use internal auditors to investigate whether ethics policies are followed Strong internal controls to prevent and detect unethical behaviors Whistleblowing policies, including reporting outlets Ethics hot line for anonymous tips Ethics statement signed by employees Enforce ethics policies fairly and take immediate action against violators

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Reward ethical behavior and include in performance evaluation system

2013 National Business Ethics Survey Exhibit 3.5 Surveys the Views of Employees from 2011-2013:  

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Observed misconduct have declined between 2011 and 2013. Pressure to compromise ethical standards declined but retaliation against whistleblowers increased; increase in ethics training programs and the use of ethical conduct in employees evaluations. 21% experienced retaliation after reporting it Six most observed types of misconduct: (1)stealing or theft, (2)falsifying time reports, (3) falsifying expense reports, (4)falsifying and manipulating financial reporting information, (5)falsifying invoices, books, and records, and (6) accepting gifts or kickbacks. Concern that while misconduct is down overall, a relatively high percentage of misconduct is committed by managers or supervisors(60%).

* The ACFE* 2018 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 The average loss from fraud was $2.75 million Frauds lasted a median of 16 months before detection Occupational fraud is use of one’s position to misappropriate organization’s resources or assets for personal gain More likely to be detected by tip, using hotlines, than any other way Asset misappropriation (cash most common) schemes most common type of occupational fraud Proactive fraud prevention and detection controls are a vital part in managing the risk of fraud

*Association of Certified Fraud Examiners *Behavioral Indicators of Fraud – red flag warnings     

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

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Complained about Inadequate Pay Refusal to Take Vacations

*Financial Statement Fraud occurs because an employee – usually top management – causes a misstatement or omission of material information in the organizations’ financial reports. Methods include:             

Revenue Overstatement Recording gross, rather than net, revenue Recording of revenues of other companies, acting as a ‘middleman’ • Recording sales that never took place Recording future sales in the current period Recording sales of products that are out on consignment Expense Understatement Recording cost of sales as a non-operating expense • Capitalizing operating costs Not recording some expense at all Improper Asset Valuations Manipulating reserves Changing the useful lives of assets Failing to take a write-down when needed Manipulating estimates of fair market value

*Why does Financial Statement Fraud Occur? 

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Situational pressure – outside financial analysts project earnings and companies feel the pressure to meet or exceed them or stocks may fall in value (eps went up 2% but were expected to go up 3% and stocks declined) Perceived opportunity –i.e. they think they can get away with it Rationalization – being able to justify the act makes it possible. Believes it may be in the best interest of the company A culture is created and tone at the top established that presents the image of a company willing to do whatever it takes to

Liability for False Certifications  

SEC’s increased focus on identifying and penalizing misstatements in public company financials Quality Services Group Inc. (QSGI) case - the CEO and CFO were held responsible for alleged misrepresentations in public disclosures about the company’s internal controls environment

Signed Form 10-Ks with management reports on internal controls that falsely omitted issues  Signed certifications in which they falsely represented that they had evaluated the management report on internal controls and disclosed all significant deficiencies to auditors Focus on Transparency with the company’s audit committee and with external auditors regarding evaluations of the company’s internal controls and whether it protects the company, its investors, and its officers 

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Has SOX Accomplished its Intended Goal?   

Section 302 requires CEO and CFO to certify financial statements contain no material misstatements This helps protect the public against fraudulent financial statements But very few defendants have been charged with false certification, and fewer still have been convicted

The former CEO of HealthSouth Corporation CEO    

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Indicted but found not guilty on false certification Weston L. Smith, current CFO, pleaded guilty in scandal, sentenced to 27 months in prison CFO of DVI pleaded guilty to mail fraud and false certification, sentenced to 30 months in prison After SOX most large corporations put in place multiple layers of subcertification, requiring lower-level officials to attest to the accuracy of the financial statements. This forces corporations to be more vigilant about financial reporting but is also has somewhat insulated CEO’s and CFO’s from false certification charges. SEC increasingly is pursuing claims against CFOs by alleging that the CFOs subordinates violated securities laws and the CFO either certified the resulting reports or failed to implement adequate internal safeguards

* The Audit Committee  

Must be Independent directors with at least one having financial expertise Has oversight of financial reporting • Internal audit function

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• External auditors • CEO and CFO financial statement certification process Reviews formal announcements of earnings, significant financial reporting judgments, review internal controls and risk management procedures, review whistleblower and compliance program, review and monitor external auditor’s independence and objectivity and effectiveness of audit process 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

* The company’s Internal Auditors –must interact with top management       

Monitor corporate governance activities and compliance with organization policies Review effectiveness of the organization’s code of ethics and whistleblower provisions “Eyes and ears” of audit committee Assess audit committee effectiveness and compliance with regulations Oversee internal controls and risk management processes Assurance on how effectively the organization assesses and manages its risk Provide assurance on data security and privacy controls

The External Auditors have    

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An obligation to the public interest that underlies their corporate governance responsibilities Protect the interests of shareholders Conduct audits independent of any influence of management or the company Communicate effectively with the audit committee: accounting policies and procedures, estimates by management; quality of financial reporting; potential violations of laws Ensures accountability for financial reporting process

*Internal Controls That are established should 

Prevent and detect errors and fraud

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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 Managers need to “walk the talk” of ethics

Internal Control Weaknesses 

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Internal control includes all of the processes and procedures that management puts in place to help make sure that its assets are protected and that company activities are conducted in accordance with the organization’s policies and procedures. An effective system of internal controls is critical to establish an ethical corporate culture that should be supported by the tone at the top. But an internal control system, no matter how well conceived and operated, can provide only reasonable - not absolute – assurance to management and the board of directors regarding achievement of an entity’s objectives. Management override of internal controls may be a problem.

*Whistleblowers These are employees (former or current) who report suspected violations to persons o...