1Commentary on Brooks Chapter 1: Ethics Expectations

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COMMENTARY ON CHAPTER 1: ETHICS EXPECTATIONS
Summary by Professor N. Jacobs
The purpose of this chapter is to provide a overvie! of the ethica" issues faci# the
accouti# professio as a resu"t of recet accouti# scada"s that have #reat"$
i%pacted the fiacia" reporti# ad auditi# processes for pu&"ic"$ traded co%paies'
I particu"ar( !e !i"" discuss those factors that have "ed to the e%er#ece of various
sta)eho"der #roups ad the ro"e these factors p"a$ i the corporate #overace process'
The e%phasis o a sta)eho"der*orieted corporate #overace process i%p"ies that
corporate %aa#ers %ust o! e+ercise their fiduciar$ duties to parties other tha %a,or
co%pa$ stoc)ho"ders' Thus( the eed to de%ostrate accouta&i"it$ to other i%portat
sta)eho"ders "i)e creditors( e%p"o$ees( activist #roups( ad stadard*setti# a#ecies has
a"tered the ature of the ecoo%ic ad operatioa" decisios of t!et$*first cetur$
co%paies' This -e!. accouta&i"it$ to %a,or sta)eho"ders is evideced &$ recet"$
eacted corporate #overace stadards for pu&"ic"$ traded co%paies ad &$ &etter
co%%uicatio &et!ee corporate &oard %e%&ers ad their costituets'
Chapter 1 examines recent trends in the ethics environment of the United States and abroad.
The implication for accounting professionals is also considered. Historically, the study of
corporate ethics has emphasied the fiduciary relationship bet!een investors and corporate
managers. Traditionally, if investors !ere displeased !ith the manager"s performance they
had opportunity to sell their stoc#, vote management out of office, or implement policies that
impact managements" responsibilities. $ue to recent accounting fiascos, a broader relationship
has been embraced by companies % one that includes not &ust shareholders, but various
sta#eholder groups as !ell. This list of sta#eholders may include activists, customers,
employees, creditors, suppliers and others.
This chapter discusses various interest groups, their demands, and the response of the business
community to these sta#eholder demands. To a large extent, corporate respect for sta#eholder values and
interests determine the ethical standing and success of a corporation. Conse'uently, corporate directors
are no! expected to govern their companies in a more ethical manner than in previous years. What has
created this demand for corporate governance, e.g., accountability Corporate governance is an
accountability frame!or# that governs the relationship bet!een corporate boards of directors,
management, internal and external auditors in the best interest of its various sta#eholders.
Several factors that appear to be associated !ith corporate governance and accountability are described
in Table 1.1. ( have modified the table appearing in this summary to include a discussion of the impetus
and implications of sta#eholder activism on corporate governance. )ccording to Table 1.1 recent factors
affecting public expectations of behavior include the environment, 'uality of life, moral sensitivity,
accountability and other concepts.
Ne! E+pectatios for /usiess
Changes in the public"s expectations of acceptable behavior have created a sieable shift in
the public"s perceptions of corporate behavior. *vents li#e human rights and improved 'uality
of life have empo!ered investors, creditors, and others to proclaim their rights to inclusion in
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0Commentary on Brooks Chapter 1: Ethics Expectations
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important economic and social decisions by corporate entities. (n years preceding the civil and
social rights movements, conventional !isdom !as that businesses could not afford to be both
ethical and profitable at the same time. Conventional !isdom, ho!ever, failed to ac#no!ledge
the bottom1line impact of externalities like industry competition, emergence of ne!
technologies, and environmental concerns.
Several important trends have developed as a result of economic and competitive pressures
that continue to impact on the ethics of corporations and their professional accountants.
. These trends include2
o *xpanding the legal liability for corporate executives and managers
o 3anagement assertions to shareholders on the ade'uacy of internal controls and
efforts to manage ris# and protect corporate reputations.
o (ncreased reliance by management on non1financial performance indicators.
)s a result of these trends, corporations have ta#en a greater interest in the effects of ethical
values on their success.
Ne! Madate for /usiess
4ver time, public expectations of corporate management have increased. The traditional profit1only
emphasis has given !ay to the vie! that businesses exists to serve society, not the other !ay around.
5hat has emerged is an emphasis on improved corporate governance6 the frame!or# that governs the
accountability relationships bet!een boards of directors, corporate managers, and internal and external
auditors. (ncreasingly, the relationship bet!een these business partners is one of interdependence, rather
than independence. 7igure 1.0 describes the function of a typical corporate governance frame!or#.
)ccording to 7igure 1.0, the boards of directors and its subcommittees are at the center of the
governance experience as they interface !ith various sta#eholder groups to set goals and policies,
provide resources and monitor feedbac# from investors, creditors, and others. The benefit of a
governance relationship is that all relevant decision1ma#ers participate in the economic decisions
relevant to them.
(n response to concerns over corporate governance, recent regulations and standards have
been enacted to reinforce the development of business ethics and to enforce standards of
accountability. (n aggregate, the result is a cumulative and heightened public a!areness of the
need for corporate ethics. Consider the follo!ing legislative initiatives" developed to create
interdependence bet!een corporations and their investors, creditors, and others.
US Corporate Sentencing 8uidelines 91//1:. This legislation heavily penalies
corporate !rong1doing, but re!ards the implementation of strategies li#e the
development of corporate codes of conduct or !histle1blo!er protection provisions %
strategies that improve the corporate governance infrastructure.
U.S. 7oreign Corrupt .ractices )ct 91/,,:. This la! re'uired companies to institute
internal control activities. (t also enacted fraud detection re'uirements for auditors.
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+Commentary on Brooks Chapter 1: Ethics Expectations
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Sarbanes14xley )ct 90--0:. S4; provisions include2
o )uditor independence, restriction of non1audit services by external auditors.
o *stablishes auditing oversight by .C)4< % The .ublic Company )ccounting
4versight <oard
o =e'uires certification of financial statements by corporate executives.
o $efines corporate governance expectations for boards of directors and audit
committees.
o *nacts !histle1blo!ing provisions for corporations.
o *valuation of systems of internal control
o =e'uires evaluation of internal controls by corporate management.
The Effectiveess of a Ne! Madate
The changes in public expectations have initiated a mandate for businesses to enhance the
'uality of life for their constituent. The vie! that business exists to serve society has replaced
the laisse1faire 9anything goes: argument that businesses are accountable to investors only>
and to the extent they report a profit. Three critical issues are considered2
1: The deviation from a profit1only focus does not mean that profits !ill fall.
)lthough it remains to be seen, it is expected that profits !ill rise !ith increased
corporate transparency and accountability.
0: .rofit is no! recognied as an incomplete measure of corporate performance and
therefore an inaccurate measure for resource allocation.
+: 3ilton 7riedman 91/,-s: argues against the myth that the unethical business is the
profitable one. 7indings consistent !ith 7riedman"s theories of economics2
=esearch has sho!n that investors consider social ob&ectives !hen deciding to
invest and that investment ob&ectives and social ob&ectives can be correlated
!ith stoc# price.
The economic performance of some ethics1based mutual funds 9typically social
accountability funds: has surpassed stoc# indices li#e the S?. @--.
The costs associated !ith AexternalitiesB have often been sho!n to be
significant. <ecause other parties can be hurt as a result of a corporate
decision. This gives a reason to include these AexternalB parties as
sta#eholders.
The Ethics Eviro%et for Professioa" Accoutats
.rofessional accountants o!e their primary loyalty to the public"s interest, not &ust to their
o!n financial interests at the expense of future shareholders. Historically, professional
accountants have been loo#ed on as the arbiters of organiational accountability and experts
in the science of decision ma#ing.
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CCommentary on Brooks Chapter 1: Ethics Expectations
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(n the accounting profession, there is a movement to!ard a globally harmonied set of
generally accepted accounting and auditing principles 98)). and 8))S: in order to provide
analytical efficiencies for the providers of capital to the !orld"s mar#ets and computational
and audit efficiencies around the !orld. 8lobaliation has come to audit firms. They are
developing global audit standards to serve their ma&or clients, and supportive behavior
standards to ensure their &udgments are independent, ob&ective, and accurate.
)ccording to 7igure1.+, corporate governance trends reflect sta#eholder satisfaction !ith
corporate board of directors, managers, and other determinants of corporate reputation.
Success factors 9hyper norms: include honesty, fairness, integrity and responsibility. )s the
accounting profession trends to!ard improving its 'uality, studies have established a
relationship bet!een these hyper norms 9universal truths:, suggesting the profession has come
full circle.
0i#ure 1'1 2eter%iats of Reputatio
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@Commentary on Brooks Chapter 1: Ethics Expectations
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Accouti# 1134
Accouti# Ethics
/roo)s Chapter 1 Co%%etar$
Ta&"e 1'1

0actors Affecti# Pu&"ic E+pectatios for /usiess /ehavior
0actor 2escriptio I%pact o Corporate 5overace
0ra%e!or)
*nvironmental concerns
and reality
Concern for the general public"s
physical !ell being6 'uality of air
and !ater, safety of )merican
citiens.
8alvaniation of public concerns for
'uality of life issues has resulted in
activist behavior and environmental
protection la!s.
3oral Sensitivity
$esire for fairness and e'uity at
home and abroad, as a result of
the pushbac# by socially
conscience groups.
Concern for civil rights, human rights,
!omen"s rights, etc. has crossed
international borders. *vidence of
public pressure for more fairness and
e'uity has resulted in codes of ethical
practice, ethics training and the
implementation of accountability
frame!or#s
<ad &udgments by
directors, executives,
and managers and the
emergence of activist
and sta#eholders.
.ublic challenges to corporate
management for operating
mista#es, earnings management,
business failures.
(nvestment and consumer issues.
*thical investors, consumers,
employees, and
environmentalists, etc.
7iduciary failures and high1ris#
accounting practices failed to consider
impact of unmanaged ris# 9business ris#,
accounting ris#s, audit ris#s, etc.: on
sta#eholders. (ncreasingly, companies
are measuring and reporting the
probability of catastrophic failure due to
unmanaged ethics ris#s in order to
minimie such ris#. )ctivism from other
social arenas 9environmentalism, human
rights, etc.: has been adapted by
corporate sta#eholders and incorporated
in sta#eholder accountability models.
Competition 8lobal pressures
7inancial scandals,
expectations gap and
credibility gap
Dumerous economic scandals,
innocent victims, and greed>
*nron, )ndersen, 5orldCom, etc.
4versight by company directors failed to
contain the greed of corporate
management. Congressional intervention
to protect sta#eholders led to passage of
Sarbanes14xley )ct, !hich strengthened
corporate governance.
)ccountability and
transparency
$emand for transparency of
financial reporting by
sta#eholders.
The trend is to!ard increased
nonfinancial reporting to match the
public"s gro!ing expectations.
Trends in the
)ccounting .rofession
Trends include2
expanding legal liability for
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ECommentary on Brooks Chapter 1: Ethics Expectations
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(nstitutional
reinforcement.
corporate directors,
management assertions to
shareholders on the ade'uacy of
internal controls, and
a stated intention to manage ris# and
protect reputations, even though
significant changes !ere also
impacting ho! organiations operate,
including2
delayering , employee
empo!erment, and the use of
electronic date interfaces, and
(ncreased reliance by management
on non1financial performance
indicators used on a real1time bas#s
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FIGURE 1.2
CORPORATE 5O6ERNANCE 0RAME7OR8
Key Board Control Functions:
Set Guidance and Boundaries
- Policies, Codes, Culture
Set Direction
- Strategies, Goals,
Remuneration, Incenties
!""oint CE#, $%o a""oints
ot%er e&ecuties
!rrange 'or Resources
(onitor Feed)ac*
- #"erations, Polic+ Com"liance,
Financial Re"orts
Re"orts to S%are%olders, Goern.
!dises on !uditor
Board o' Directors
, Su)committees-
!udit, Goernance,
Com"ensation
S%are%olders
Sta*e%olders
!uditor
Elect
Legend: Info Flow Actions
FCommentary on Brooks Chapter 1: Ethics Expectations
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0i#ure 1'1 2eter%iats of Reputatio
Corporations began to ta#e a great interest in ho! ethical their activities
!ere because of these trends.
3anagement based on values, reputation, and ris#s2
Hypernorms 9values that are respected by most groups or cultures around the
!orld6 basic values: Underlying Sta#eholder (nterests2 Hypernorms involve
the demonstration of honesty, compassion, predictability, fairness, integrity,
and responsibility.
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/Commentary on Brooks Chapter 1: Ethics Expectations
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7inally, a list of representative ethics ris#s is presented in Table 1.@. The importance of ethics ris#
management is to anticipate the li#elihood of unethical outcomes>and their impact on corporate
sta#eholders of )merica. <ecause these ethics ris#s have become strongly associated !ith the
reputation of corporations and entire industries, millions are spent on the ris# management
process.
Ta&"e 1'9
Ethics Ris)s* A Represetative :ist
Sta*e%olders E&"ectations .ot (et Et%ics Ris* Et%ics Ris*
S h a r e h o l d e r s
S t e a l i n g , m i s u e s o f f u n d s o r a s s e t s h o n e s t , i n t e r g r i t y
C o n f l i c t o f i n t e r e s t s w i t h o f f i c e r s p r e d i c t a b i l i t y , r e s p o n s i b i l i t y
P e r f o r m a n c e L e v e l r e s p o n s i b i l i t y , h o n e s t y
R e p o r t i n g t r a n s p a r e n c y , a c c u r a c y h o n e s t y , i n t e g r i t y
E m p l o y e e s
S a f e t y F a i r n e s s
D i v e r s i t y f a i r n e s s
C h i l d a n d o r s w e a t s h o p l a b o r c o m p a s s i o n , f a i r n e s s
C u s t o m e r s
S a f e t y f a i r n e s s
P e r f o r m a n c e f a i r n e s s , i n t e g r i t y
E n v i r o n m e n t a l i s t s
P o l l u t i o n i n t e g r i t y , r e s p o n s i b i l i t y
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