Ethics of accounting information
Creative accounting, earnings management, misleading financial analysis.
Insider trading, securities fraud, bucket shop, forex scams: concerns (criminal) manipulation of the financial
markets.
Executive compensation: concerns excessive payments made to corporate CEO's.
Bribery, kickbacks, facilitation payments: while these may be in the (short-term) interests of the company and
its shareholders, these practices may be anti-competitive or offend against the values of society.
Business ethics is a form of the art of applied ethics that examines ethical principles and moral or ethical
problems that can arise in a business environment.
In the increasingly conscience-focused marketplaces of the 21st century, the demand for more ethical business
processes and actions (known as ethicism) is increasing.[1] Simultaneously, pressure is applied on industry to
improve business ethics through new public initiatives and laws (e.g. higher UK road tax for higher-emission
vehicles).[2]
Ethics of accounting information
1. Creative accounting and earnings management
accounting practices that may or may not follow the letter of the rules of standard accounting practices
but certainly deviate from the spirit of those rules. The term as generally understood refers to
systematic misrepresentation of the true income and assets of corporations or other organizations.
"Creative accounting" is at the root of a number of accounting scandals, and many proposals for
accounting reform - usually centering on an updated analysis of capital and factors of production that
would correctly reflect how value is added.
{ Accounting scandals = or corporate accounting scandals are political and business scandals which arise
with the disclosure of misdeeds by trusted executives of large public corporations. Such misdeeds
typically involve complex methods for misusing or misdirecting funds, overstating revenues,
understating expenses, overstating the value of corporate assets or underreporting the existence of
liabilities, sometimes with the cooperation of officials in other corporations or affiliates.
In public companies, this type of "creative accounting" can amount to fraud and investigations are
typically launched by government oversight agencies, such as the Securities and Exchange Commission
(SEC) in the United States.
In 2002, a wave of separate but often related accounting scandals became known to the public in the
U.S. All of the leading public accounting firms—Arthur Andersen, Deloitte & Touche, Ernst & Young,
KPMG, PricewaterhouseCoopers— and others have admitted to or have been charged with negligence
in the execution of their duty as auditors to identify and prevent the publication of falsified financial
reports by their corporate clients which had the effect of giving a misleading impression of their client
companies' financial status. In several cases, the monetary amounts of the fraud involved are in the
billions of USD.}
Creative accounting tactics
Although not technically wrong, many annual and quarterly reports and presentations dive heavily into
theoretical scenarios where "one-time charges" to earnings are excluded. What this means is for
example, a lawsuit settlement amount would be taken out of the reported profit in one big chunk, even
if it is paid out little by little over time (this practice is called reserving). Often, when explaining the
quarterly results, a CEO might say "Well if we didn't take this charge for the lawsuit, we would have
made this much money". Very often, the hypothetical situations proposed get even more complicated.
The main "creative" aspect to this is when a "one time" "exceptional" charge really is something that is
very common to the business.
Banks are able to lend out most of the money they receive in deposit (they also can lend money they
borrow from other banks). However, to protect against bad loans, banks must keep aside a supply of
money called a "reserve". The bank, within general guidelines, gets to set the size of this reserve to what
it feels is prudent compared to how risky its outstanding loans are. However, when the bank wants to
make it look like it made more money this quarter than last, one way to do that is to take money from
the reserve and call it profit with the excuse that the loans are safer now than before and that amount
was no longer needed.
One of the main genres of "creative accounting" is known as slush fund accounting, whereby some
earnings from this quarter are hidden away just in case the profit from next quarter is not enough for
the management to make their bonuses. This happened most famously at Freddie Mac. As of 2004 there
is a large investigation underway to see if retroactive insurance policies from insurers such as General Re
of Berkshire Hathaway were used for slush fund accounting. The question is if these insurance policies
truly transferred some risk or were merely a slush fund.
Creative accounting is not limited to large firms with banks of accountants. Smaller companies often use
creative accounting, but for tax saving purposes rather than meeting bonuses or shareholder
expectations. Salaries are sometimes included in profits to benefit from corporation tax rates being
lower than personal tax rates and spouses are sometimes put on the books as employees though they
may never have worked for the company. As smaller companies are generally subject to less onerous
rules - and many of them fall below the limit required for a full annual audit every year - much of the
creative accounting in this sector does not get a lot of publicity.
Earnings Management
According to Healy and Wahlen (1999), "Earnings Management" occurs when managers use judgement
in financial reporting and in structuring transactions to alter financial reports to either mislead some
stakeholders about the underlying economic performance of a company or to influence contractual
outcomes that depend on reported accounting numbers.
Earnings management usually involves the artificial increase (or decrease) of revenues, profits, or
earnings per share figures through aggressive accounting tactics. Aggressive earnings management is a
form of fraud and differs from reporting error.
Management wishing to show earnings at a certain level or following a certain pattern seek loopholes in
financial reporting standards that allow them to adjust the numbers as far as is practicable to achieve
their desired aim or to satisfy projections by financial analysts. These adjustments amount to fraudulent
financial reporting when they fall 'outside the bounds of acceptable accounting practice'. Drivers for
such behaviour include market expectations, personal realisation of a bonus, and maintenance of
position within a market sector. In most cases conformance to acceptable accounting practices is a
matter of personal integrity. Aggressive earnings management becomes more probable when a
company is affected by a downturn in business.
Earnings management is seen as a pressing issue in current accounting practice. Part of the difficulty lies
in the accepted recognition that there is no such thing as a single 'right' earnings figure and that it is
possible for legitimate business practices to develop into unacceptable financial reporting.
It is relatively easy for an auditor to detect error but earnings management can involve sophisticated
fraud that is covert. The requirement for management to assert that the accounts have been prepared
properly offers no protection where those managers have already entered into conscious deceit and
fraud. Auditors need to distinguish fraud from error by identifying the presence of intention.
The main forms of earnings management are as follows:
unsuitable revenue recognition
inappropriate accruals and estimates of liabilities
excessive provisions and generous reserve accounting
intentional minor breaches of financial reporting requirements that aggregate to a material breach.
2. Financial analysis of an organisation is misleading when it is used to misrepresent the organisation, its
situation or its prospects.
This type of deceit is sometimes used to obtain money by misdirecting people to invest in a stock
market bubble, profiting (or assisting others to profit) from the increase in value, then removing funds
before the bubble collapses, for instance in a stock market crash.
Regulators exist to try to prevent such fraud.
{A stock market bubble is a type of economic bubble taking place in stock markets when price of stocks rise
and become overvalued by any measure of stock valuation.}
{A stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a
stock market. Crashes are driven by panic as much as by underlying economic factors. They often follow
speculative stock market bubbles.
Wall Street Crash of 1929
The most famous crash, the Wall Street Crash of 1929, happened on October 29, 1929. The economy
had been growing robustly for most of the so-called Roaring Twenties. It was a technological golden age
as innovations such as radio, automobiles, aviation, telephone and the power grid were deployed and
adopted. Companies who had pioneered these advances like Radio Corporation of America (RCA), and
General Motors saw their stocks soar. Financial corporations also did well as Wall Street bankers floated
mutual fund companies (then known as investment trusts) like the Goldman Sachs Trading Corporation.
Investors were infatuated with the returns available in the stock market especially with the use of
leverage through margin debt. On August 24, 1921, the Dow Jones Industrial Average stood at a value of
63.9. By September 3, 1929, it had risen more than sixfold, touching 381.2. It would not regain this level
for another twenty five years. Even during the summer of that year it was clear that the economy was
contracting and the stock market soon went through a series of unsettling price declines in early
October. These declines fed investor anxiety and events soon came to a head. October 24 (known as
Black Thursday) was the first in a number of increasingly shocking market drops. This was followed
swiftly by Black Monday on October 28 and Black Tuesday on October 29.
On Black Monday, the Dow Jones Industrial Average fell 38 points to 260, a drop of 12.8%. The deluge of
selling overwhelmed the ticker tape system that normally gave investors the current prices of their
shares. Telephone lines and telegraphs were clogged and were unable to cope. This information vacuum
only led to more fear and panic. The technology of the New Era, much celebrated by investors
previously, now served to deepen their suffering.
Black Tuesday was a day of chaos. Forced to liquidate their stocks because of margin calls, overextended
investors flooded the exchange with sell orders. The glamour stocks of the age saw their values
plummet. Radio Corporation plunged from $40.25 to $26 in the first two hours of trading (down $75
from its historic peak). The Goldman Sachs Trading Corporation opened at 60 and closed at 35. The First
National Bank of New York declined from $5200 to $1600.[1] Across the two days, the Dow Jones
Industrial Average fell 23%.
By the end of the week of November 11, the index stood at 228, a cumulative drop of 40 percent from
the September high. The markets rallied in succeeding months but it would be a false recovery that led
unsuspecting investors into the worst economic crisis of modern times.
Although it is popularly believed that the Crash inflicted heavy financial loss on investors during this
period, the Great Depression which followed was far more terrible. While the Crash dealt a severe blow
to many a stockholder's portfolio, the Great Depression brought obliteration and bankruptcy. Before it
was over, the Dow Jones Industrial Average would lose 89% of its value before finally bottoming out in
July 1932. }
3. Insider trading
4. Securities fraud
Securities fraud, also known as investment fraud, is a practice where investors are deceived and
manipulated, resulting in theft.[1] The elements of the crime are theft of capital from investors and
defrauding the accounting companies about a corporation's financial reports.
This white collar crime has become increasingly frequent as the Internet and the World Wide Web have
given white collar criminals greater access to their intended victims. The trading volume in the United
States securities and commodities markets, having grown dramatically in the 1990s, has led to an
increase in fraud and misconduct by investors, executives, shareholders, and other market participants.
Securities regulators and other prominent groups have estimated that civil securities fraud totals
approximately $40 billion per year. Fraudulent schemes perpetrated in the securities and commodities
markets can ultimately have a devastating impact on the viability and operation of those these markets.
Increase of securities fraud
Securities fraud is becoming more complex as the industry develops more complicated investment
vehicles in an effort to obtain higher rates of return. In addition, white collar criminals are expanding the
scope of their fraud and are looking outside the United States for new markets, new investors to
defraud, and banking secrecy havens to hide their unjust enrichment. The securities industry is one of
the most critical and influential industries in the country and is regulated by the SEC.
A study conducted by the New York Stock Exchange in the mid-1990s revealed that approximately 51.4
million individuals owned some type of traded stock, and an additional 200 million individuals owned
securities indirectly. These same financial markets provide the opportunity for wealth to be obtained
and the opportunity for white collar criminals to take advantage of unwary investors who desire to make
honest income and to not be swindled.
Asset recovery
Recovery of assets from the proceeds of securities fraud is a resource intensive and expensive
undertaking because of the cleverness of fraudsters in concealment of assets and money laundering, as
well as the tendency of many criminals to be profligate spenders. A victim of securities fraud is usually
fortunate to recover any monies from the defrauder.
Potential victims
Any investor can become a victim of this crime, but persons aged 50 years or older are most often
victimized by securities fraud, whether as direct purchasers in securities or indirect purchasers through
pension funds. Not only do investors lose: so can creditors, taxing authorities, and innocent employees.
Potential perpetrators
Potential perpetrators of securities fraud within a publicly-traded firm include any dishonest official
within the company who has access to the payroll or financial reports that can be manipulated to:
overstate assets
overstate revenues
understate costs
understate liabilities
Enron Corporation exemplifies all four tendencies, and its failure demonstrates the extreme dangers of a
culture of corruption within a publicly-traded corporation. The rarity of such spectacular failures of a
corporation from securities fraud attests to the general reliability of most executives and boards of large
corporations. Most spectacular failures of publicly-traded companies result from such innocent causes
as marketing blunders (Schlitz), an obsolete model of business (Penn Central, Woolworth's), inadequate
market share (Studebaker), or non-criminal incompetence (Braniff).
Other effects of securities fraud
Even if the effect of securities fraud is not enough to cause bankruptcy, a lesser level can wipe out
holders of common stock because of the leverage of value of shares upon the difference between assets
and liabilities. Such fraud has been known as watered stock, analogous to the practice of force-feeding
livestock great amounts of water to inflate their weight before sale to dealers.
5. Bucket shop
Bucket shop has three meanings:
1. A pejorative colloquial phrase which refers to different kinds of businesses, indicating that the speaker
believes it is a fraud or scam.
2. A brokerage enterprise that “books" (i.e., takes the opposite side of) retail customer orders without
actually having them executed on an exchange.[1]
3. Another name for airline ticket consolidators.
""Bucket Shop"" is a specifically defined term under the criminal law of many states in the United States
which make it a crime to operate a bucket shop. [2] Typically the criminal law definition refers to an
operation in which the customer is sold what is supposed to be a derivative interest in a security or
commodity future, but there is no transaction made on any exchange. The transaction goes 'in the
bucket' and is never executed. Without an actual underlying transaction, the customer is betting against
the bucket shop operator, not participating in the market. Operating a bucket shop would also likely
involve violations of several provisions of US federal securities or commodity futures laws
House stock scam
The term bucket shop is now applied to any fraudulent stock-selling operation such as a boiler room,
which has an undisclosed relationship with the company being promoted or undisclosed profit from the
sale of house stock being promoted. A bucket shop promotes (via telephone or email) thinly traded or
even fraudulent investments.
Heraldic scam
An "heraldic bucket shop" is a heraldry company that will sell a coat of arms associated with the
customer's surname. Sometime a company will create a coat of arms for a surname that never had a
coat of arms. These coats of arms are almost always those of someone long-dead and of no relation to
the customer. Most bucket shops maintain computerized data-bases, or buckets, compiled from old
manuscripts, armories, or ordinaries. In most European traditions, a coat of arms must be inherited. Just
because someone named "Smith" possessed a coat of arms does not mean that everyone named
"Smith" has a right to use that armorial achievement.
6. A forex scam is any trading scheme used to defraud individual traders by convincing them that they can
expect to gain an unreasonably high profit by trading in the foreign exchange market, which would be a
zero-sum game were it not for the fact that there are brokerage commissions, which technically make
forex a "negative-sum" game.
These scams might include churning of customer accounts for the purpose of generating commissions,
selling software that is supposed to guide the customer to large profits,[1] improperly managed
"managed accounts",[2] false advertising,[3] Ponzi schemes and outright fraud.[4] It also refers to any
retail forex broker who indicates that trading foreign exchange is a low risk, high profit investment.
{In game theory, zero-sum describes a situation in which a participant's gain or loss is exactly balanced
by the losses or gains of the other participant(s). It is so named because when the total gains of the
participants are added up, and the total losses are subtracted, they will sum to zero}
7. Executive compensation
concerns excessive payments made to corporate CEO's.
8. Bribery
Bribery is a crime implying a sum or gift given that alters the behavior of the person in ways not
consistent with the duties of that person. It is defined by Black's Law Dictionary as the offering, giving,
receiving, or soliciting of any item of value to influence the actions as an official or other person in
discharge of a public or legal duty. The bribe is the gift bestowed to influence the receiver's conduct. It
may be any money, good, right in action, property, preferment, privilege, emolument, object of value,
advantage, or any promise or undertaking to induce or influence the action, vote, or influence of a
person in an official or public capacity.
a construction company may bribe a civil servant to award a contract,
Employees, managers, or salespeople of a business may offer money or gifts to a potential client in
exchange for business. For instance, the service company Aramark was recently accused of offering gifts
to an assistant warden in the New Mexico Prison System in exchange for a contract allowing Aramark to
provide the food services in the state's prisons.
More recently, in 2006 German prosecutors conducted a wide-ranging investigation of Siemens AG to
determine if Siemens employees paid bribes in exchange for business.
In some cases where the system of law is not well implemented, bribes may be a way for companies to
continue their businesses. In the case, for example where custom officials harass a certain firm or
production plant, officially stating to check for irregularities, may halt production and stall other normal
activities of a firm. The disruption may cause losses to the firm that exceed the amount of money to pay
off the official. Bribing the officials is a common way to deal with this issue in countries where there
exists no firm system of reporting these semi-illegal activities. The third party, known as the White Glove
may be involed to act as a clean middleman.
Specialists consultancies such as Interchange Solutions Limited (UK) have been set up to help
multinational companies and SMEs, with a commitment to anti-corruption, to trade more ethically and
benefit from compliance with the law.
9. Kickback
Kickback usually refers to:
Political corruption
Bribery
It can also refer to:
A variant of Blackwood convention in contract bridge
10. Facilitation payment
A facilitation payment is an ethically questionable payment made in order to procure or speed up the provision
of services.
A distinction is generally drawn between facilitation payments and outright bribery and corruption. In many
countries it may be considered normal (and actually be legal) to provide small unofficial payments in certain
circumstances. A multinational company may be prohibited by law from making such payments in its home
country, and therefore encounters an ethical problem when doing business in a country in which facilitation
payments are a part of the business process.
