1. EthicsEthics presented by Heidi Tribunella, MS, CPA, Clinical Associate Professor of Accounting, Simon Graduate School of Business, University of Rochester Thomas Tribunella, MBA, PhD, CPA, Professor of Accounting, School of Business, SUNY Oswego August 12, 2014 Insero & Companys 2014 Accounting & Finance Education Series

2. Objectives Covered 1. Introduction to ethical thought: Distinguishing between ethical and unethical behavior in personal and professional contexts. 2. Review some of western historys greatest philosophers. 3. Discuss various ethical theories. 4. Review information ethics and explain the necessity of ethical conduct for the accounting profession. 5. Resolve ethical dilemmas using the Frame, Analyze and Communicate (FACt) approach and consider decision making steps for ethical choices. 6. Examine the nature of fraud and white collar crime. 2 3. 3 Objectives Covered 7. Discuss who commits fraud and the reasons why. 8. Review computer fraud and abuse techniques. 9. Provide an overview of the AICPA Ethics Codification Project. 10. Show the organization of topics in the Code of Professional Conduct. 11. Review the conceptual framework for members in public practice. 12. Review the conceptual framework for independence. 4. 4 Objectives Covered (Cont.) 13. Review the conceptual framework for members in business. 14. Review rules and interpretations applicable to members in business. 15. Apply the AICPA code to different fraud cases. 16. Detail how the AICPA rules of conduct are enforced. 17. Review the NYSSCPA Code of Conduct. 5. Objective 1 Introduction to ethical thought: Distinguishing between ethical and unethical behavior in personal and professional contexts. 5 6. Ethics Ethics are the principles and standards that guide our behavior toward other people. Ethics are rooted in history, culture, and religion. May differ from person to person, country to country, or culture to culture. The study of ethics is the story of personal ethical choices (descriptive). 6 7. Ethics It is also the study of how professionals should act (normative and prescriptive) according to social and professional responsibility. But there is a big difference between how professionals should act and how they do act. Many individuals seek to maximize their personal utility by making choices that benefit themselves. These personal choices may be different than choices based on virtue and ethics. 7 8. 8 Need for Ethics In order for a society to operate in a rational manner, ethical behavior needs to be practiced by its members. Individuals cannot interact with each other if they cannot trust each other. Certain ethical behaviors are written into the laws of the society. In American we are a nation of laws, not of men, according to John Adams. 9. 9 Examples of Ethical Principles Honesty Respect for others Fairness Trustworthiness Responsibility Caring for others Giving of ones talents 10. 10 Why People Act Unethically The persons ethical standards differ from the normal average person within the society. The person chooses to act in an unethical manner. Both a and b. 11. Ethics The conflict between ethics and personal gain has motivated the writings of many of historys greatest thinkers. Ethics has been addressed by some of historys most well known philosophers. Socrates, Plato, Aristotle as well as the founding fathers of the US all discussed ethics. Every major religion and culture has established ethical beliefs. We cannot review all ethics philosophy in this short presentation. But we can cover some western thought and the ethical theories that lead to current day professional ethics. 11 12. Objective 2 Review some of western historys greatest philosophers. 12 13. Socrates 469 BC 399 BC This classical Greek philosopher is credited as a founder of Western philosophy. Through his portrayal in Plato's dialogues, Socrates has become renowned for his contribution to the field of ethics and the Socratic method. The method remains a commonly used tool in which a series of questions are asked not only to draw individual answers, but also to encourage fundamental insight into the issue at hand. The influence of his ideas and the Socratic approach remains strong in providing a foundation for much of the western philosophy. 13 14. Socrates Socrates believed the best way for people to live was to focus on self-development rather than the pursuit of material wealth. He encouraged others to concentrate on friendships and a sense of community, he believed this was the best way for people to grow together as a civil society. His actions lived up to his words: for example, Socrates service to Athens and his reputation for valor on the battlefield was well known. 14 15. Socrates The idea that humans possessed certain virtues formed a theme in Socrates' teachings. Philosophical and intellectual virtues represented the most important qualities for a person to have. Socrates stressed that virtue was the most valuable of all possessions; the ideal life was spent in search of the Good. He believed that truth and virtue exists and humans are capable of knowing it through questioning their beliefs and observing the world. However, it is one of the jobs of the philosopher to show his students how little they really know by questioning their positions. 15 16. Socratic Method Applied to Professional Ethics Socrates once said, I know you won't believe me, but the highest form of Human Excellence is to question oneself and others. Beliefs: Am I acting consistently with my beliefs? If not, why is this situation an exception to my beliefs? Have I contradicted myself? Laws: Am I in compliance with professional and legal standards? Have I reviewed my decision with a well- informed and unbiased third party? Fairness: Would I want to be treated the same way as I treat others? Am I being fair, just, unprejudiced and even- handed? 16 17. Socratic Method Applied to Professional Ethics Logic: Did I make the decision while I was feeling emotional? Is my decision logical? Can the decision be explained to others and understood by others? Honesty: Am I being open, honest and truthful? Have I explicitly stated all relevant facts? Will the decision stand up to daylight and public scrutiny? Community: Will I be proud of this decision in the future? Would my family, friends and peers respect my decision? Does this decision serve the best long-run interests of my customers, investors and professional community? 17 18. Auditing and the Socratic Method Auditing is the act of questioning the fairness of financial statements. Internal and external auditors examine and question account balances (substantive testing of variables). They also question compliance with internal controls to judge their impartiality (attributes testing). This method helps to protect the property rights of investors and creditors. 18 19. Hippocrates: 460 BC 370 BC He was an ancient Greek physician of Classical Athens and is considered one of the most prominent figures in the history of medicine. He was the founder of the Hippocratic School of Medicine. The school revolutionized medicine in ancient Greece by establishing it as a discipline distinct from other fields such as theology, thus instituting medicine as a separate profession. He also greatly advanced the systematic study of clinical medicine, summarized the medical knowledge of previous generations, and prescribed practices for physicians through the Hippocratic Corpus and other works. 19 20. Hippocratic Theory Hippocrates is credited with being the first person to believe that diseases were caused naturally, not because of superstition and gods. He argued that disease was not a punishment inflicted by the gods but rather the product of environmental factors, diet, and living habits. Accordingly, there is not a single mention of a mystical illness in the Hippocratic Corpus. The Hippocratic school achieved great success by applying general diagnoses and passive treatments. With a focus on patient care, it advanced the treatment of diseases and allowed for significant developments in clinical practice. 20 21. Professionalism and the Hippocratic Oath The Oath required a new physician to swear that he will uphold a number of professional ethical standards. It is believed to have been written by Hippocrates who is regarded as the father of western medicine. Still today 2,400 years later, the oath is considered a rite of passage for practitioners of medicine in many countries. 21 22. Hippocrates combined the philosophy of science with medicine. The medical profession and its philosophy of science, logic and rational thought lead the way for the professionalization of many other fields. Today the vast majority of professions not only require training but the practitioners must adhere to a code of professional ethics. This tradition has its roots in ancient Greek philosophy. The Start of Professions 22 23. Hippocrates and the 4 Es Education Experience Examination Ethics 23 24. Plato: 423 BC 348 BC He was a classical Greek philosopher, a student of Socrates, and founder of the Academy in Athens, the first institution of higher learning in the Western world. Along with his mentor, Socrates, and his student, Aristotle, Plato helped to lay the foundations of Western philosophy and science. Plato's Socratic dialogues have been used to teach a range of subjects, including philosophy, logic, ethics, rhetoric, and mathematics. 24 25. Aristotle: 384 BC 322 BC The student of Plato and tutor to Alexander the Great. Authored many scrolls on virtue and the soul as well as helped to develop the concept of ethics. Aristotle argued that the correct approach to studying ethics is to start with what people of good up-bringing and experience would agree to be true about ethics. To start with worldly observations and work up to a higher theoretical understanding. 25 26. Aristotelian Ethics Ethics and virtue can be known through observation and rational thought (natural laws). Individuals should be free to choose to do the right thing on a regular basis as they live life (natural rights). Righteous actions can be taught by leaders, philosophers and teachers (training). 26 27. Aristotelian Virtues A person of "great soul" is someone who would be truly generous and altruistic and therefore deserving of high praise. A virtuous person is a just and fair leader in a good community (a republic). A virtuous person exercises good practical judgment and is a good representative (or manager). A virtuous person is a trustable, reliable and a truly good friend. 27 28. Marcus Cicero: 106 BC 43 BC Cicero was a Roman philosopher, lawyer, and constitutionalist. He is widely considered one of Rome's greatest orators. He introduced the Romans to Greek philosophy and distinguished himself as a linguist and philosopher. 28 29. Cicero Medieval philosophers were influenced by Cicero's writings on natural laws and rights. The rediscovery of Cicero's writings created interest in ancient Greek writings and motivated the search for Classical Antiquity that led the west out of the dark ages to the Renaissance in the 14th century. Following the invention of the printing press, Cicero's letters was the second book to be printed after the Gutenberg Bible. 29 30. Cicero Ciceros republican philosophy inspired the Founding Fathers of the United States. John Adams said of him "As all the ages of the world have not produced a greater statesman and philosopher united than Cicero, his authority should have great weight." Thomas Jefferson named Cicero as one of a handful of major figures who contributed to a tradition of public rights that guided his draft of the Declaration of Independence and shaped the American understanding of the common sense basis for natural rights. 30 31. Thomas Aquinas: 1225 1274 He was an Italian Dominican priest of the Roman Catholic Church, and an immensely influential philosopher and theologian. He was the foremost classical proponent of natural theology. His influence on Western thought is considerable, particularly in the areas of ethics, natural law, metaphysics, and political theory. Much of modern philosophy was conceived as a reaction against or as an agreement with, his ideas. 31 32. Luca Pacioli: 1445 1517 Was an Italian mathematician, Franciscan friar, and collaborator with Leonardo da Vinci. A seminal and significant contributor to the fields of accounting and math. His writings including the first published description of bookkeeping that Venetian merchants used during the Italian Renaissance known as the double-entry accounting system. The system he published included most of the accounting cycle as we still practice it today, 500 years later. 32 33. Luca Pacioli Also, his treatise touches on a wide range of related topics from accounting ethics to cost accounting. His ethics were very applied: stay organized, keep your books in balance, work hard, develop good math skills, get up early, do not be wasteful, and keep track of costs. 33 34. Luca Pacioli He described the use of journals and ledgers as well as the rules that state debits equaled credits and that assets equal liabilities plus equity. The balance sheet was developed as a mathematical expression of property rights (a natural right). Asset (business property) = Liabilities (creditor property) + Equity (owner property) 34 35. John Locke: 1632- 1704 His contributions to classical republicanism and liberal theory are reflected in the United States Declaration of Independence. Locke's theory of mind is often cited in the work of later philosophers such as Hume and Kant. He believed the mind was a blank slate and posited we are born without innate ideas and knowledge is determined only by experience derived from sense and perception. Locke uses the term property in both broad and narrow senses. In a broad sense, it covers a wide range of human interests and aspirations. More narrowly property refers to material goods. He argues that property is a natural right and it is derived from labor. 35 36. Locke Locke argues that the individual ownership of goods and property is justified by the labor exerted to produce that property. He also believed that the production of goods is beneficial to human society. Locke stated his belief that nature on its own provides little of value to society; he postulated that labor expended in the creation of goods gives them their value. Accordingly, Locke believed that ownership of property is created by the application of labor. In addition, he believed property precedes government and government cannot "dispose of the estates of the subjects arbitrarily." Karl Marx later critiqued Locke's theory of property in his own social theory. 36 37. Immanuel Kant: 1724 1804 Kant's method involves trying to convert our everyday, obvious, rational knowledge of morality into philosophical knowledge. Using practical (deductive) reasoning to reach conclusions which are able to be applied to the real world of experience and choice. Deductive reasoning involves using given true premises to reach a conclusion that is also true. But not deriving any principles from personal experience. 37 38. Kant He thought that action should have pure intentions behind it. Kant believed that an action should be done with the motive of duty and have moral value. He did not necessarily believe that the final result was the most important aspect of an action. How the person felt while carrying out the action was the value that applied to the result. Kant also posited the counter-utilitarian idea that considerations of individual rights temper calculations of aggregate utility (a concept that is a principle in economics). 38 39. Adam Smith: 1723 to 1790 Smith was a Professor of Moral Philosophy at the University of Glasgow in Scotland author of The Theory of Moral Sediments. A significant figure in the Scottish Enlightenment he worked with David Hume. Known as the father of economics and capitalism since An Inquiry into the Nature and Causes of the Wealth of the Nations established the field of modern economics. 39 40. Smith The Theory of Moral Sentiments culminated in man as self-interested and self-commanded individual. In Moral Sentiments Smith first referred to the "invisible hand" to describe the benefits to society of people pursuing their own interests. Individual freedom, according to Smith, was rooted in self-reliance, the ability of an individual to pursue his self-interest while commanding himself based on the principles of natural laws and rights. 40 41. Smith Smith writes: ... In spite of their natural selfishness and rapacity, though they mean only their own conveniency, though the sole end which they propose ... be the gratification of their own vain and insatiable desires, they divide with the poor the produce of all their improvements. They are led by an invisible hand to make nearly the same distribution of the necessaries of life, which would have been made, had the earth been divided into equal portions among all its inhabitants, and thus without intending it, without knowing it, advance the interest of the society. 41 42. Smith In other words, when the business owner pursues wealth they create jobs, serve customers and enrich investors as an untended consequence of their self enlightened actions. By serving themselves, they serve the greater good of society. Their intentions are irrelevant (the opposite of Immanuel Kant). The interests of the rich are aligned with the needs of the poor. 42 43. David Hume: 1711 - 1776 Hume strove to create a total naturalistic "science of man" that examined the psychological basis of human nature. In stark opposition to the rationalists who preceded him (such as Immanuel Kant), he concluded that desire rather than reason governed human behavior. A prominent figure in the skeptical philosophical tradition and a strong empiricist, he argued against the existence of innate ideas, concluding instead that humans have knowledge only of things they directly experience. 43 44. Hume He developed the position that mental behavior is governed by customs and our use of induction (inferring general principles or rules from specific observable facts). For example, our actions are justified only by our idea of observable causes and effects. He concluded that humans have no actual conception of the self, only of a bundle of experiences associated with the self. He was also held that ethics are based on feelings rather than abstract moral principles. In other words, you are a product of your experiences and environment. 44 45. John Stuart Mill: 1806 1873 Utilitarianism was described by John Stuart Mill as the greatest happiness principle". Is an ethical theory holding that the proper course of action is the one that maximizes the overall "happiness". His harm principle holds that each individual has the right to act as he wants, so long as these actions do not harm others. It is a form of consequentialism, meaning that the moral worth of an action is determined only by its resulting outcome, and that one can only weigh the morality of an action after knowing all its consequences. 45 46. Karl Marx: 1818 1883 Marx's theories hold that all societies progress through class struggle. This is a conflict between an ownership class which controls production and a lower class which produces the labor for goods. Heavily critical of capitalism, he believed capitalism to be run by the wealthy classes purely for their own benefit. He predicted that capitalism would inevitably produce internal tensions which would lead to its self-destruction and replacement by a new system of socialism. 46 47. Marx He argued that under socialism, society would be governed by the working class in what he called the workers' democracy. He believed that socialism would eventually be replaced by a stateless, classless society called communism. Marx arguing that both social theorists and underprivileged people should carry out organized revolutionary action to topple capitalism and bring about socio-economic change. He believed that it is ethical to confiscate private property from capitalists and redistribute it to workers. He believed in physical rights such as a right to food and education (positive rights and entitlements). Marx failed to adequately address the behavioral effect of incentives on individual behavior. 47 48. Joseph Schumpeter: 1883 1950 Supported the idea of Creative Destruction which is the process of transformation that accompanies innovation. Entry by entrepreneurs creates new products and business models which sustains long-term economic growth, even though it may destroy the value of established companies. Disruptive technologies do not collapse the system but allow for human progress. Creative destruction is also known as social Darwinism or economic Darwinism. 48 49. Schumpeter: Examples of Creative Destruction Cassette tape replaced the 8-track. Compact disc replaced records, cassette and video tapes. Compact disc is now being undercut by MP3 players and downloadable media. Wal-Mart has achieved a strong market position, through its use of supply chain efficiency, marketing, and personnel-management techniques, to lower prices and gain market share over older or smaller companies such as Kmart and Sears. 49 50. Objective 3 Discuss various ethical theories. 50 51. Various approaches to Ethics Utilitarian Approach: produces the greatest good over harm, a moral theory that says that what is morally right is whatever produces the greatest overall good for the greatest number. Utilitarianism is attributed to the work of J.S. Mill. It is an approach that emphasizes the result or the outcome. Fairness or Justice Approach: all equals should be treated equally. Common Good Approach: life in a community is a good that should be supported by the actions of individuals. Legal Approach: the letter of the law must be obeyed. Natural Law: believers in natural law hold that there is a natural order to the human world, that this natural order is good, and that people should not violate that order. 51 52. Ethics Natural Rights: are human rights that are universal and inalienable. They do not come from governments but from our creator and are rational, logical and self evident. They cannot be taken away by law, democracy, or a king. They are the basis for the Magna Carta, Declaration of Independence, and the US Constitution. Libertarianism: refers to a political philosophy maintaining that all persons are the absolute owners of their own lives. Individuals should be free to do whatever they wish with their persons or property as long as they allow others the same liberty. Libertarians favor an ethic of self-responsibility and strongly oppose the welfare state. They believe forcing someone to provide aid to others is ethically wrong and ultimately counter- productive. 52 53. Ethics Pluralism: The belief that there are multiple perspectives on an issue, each of which contains part of the truth but none of which contain the whole truth. In ethics, moral pluralism is the belief that different moral theories each capture part of truth of the moral life, but none of those theories has the entire answer. Relativism: In ethics, there are two main types of relativism. Descriptive ethical relativism simply claims that different people have different moral beliefs, but it takes no stand on whether those beliefs are valid or not. Normative ethical relativism claims that each cultures (or groups) beliefs are right within that culture and that it is impossible to validly judge another cultures values from the outside. 53 54. Ethics Rights Approach: best protects the rights of those affected. Rights are entitlements to do something without interference from other people (negative rights) or entitlements that obligate others to do something positive to assist you (positive rights). Some rights (natural rights, human rights) belong to everyone by nature or simply by virtue of being human. Legal rights belong to people by virtue of their membership in a particular political state. Moral rights are based in acceptance of a particular moral theory. Personal Virtue: is based on the work of Aristotle, Plato, and Socrates. It reinforces that we should act in ways that convey a sense of honor and self-worth. Ethical actions should be consistent with virtues such as honesty, courage, compassion, generosity, tolerance, love, fidelity, integrity, fairness, self- control, prudence, etc 54 55. Ethics Economic Darwinism: in a competitive world, if surviving organizations use a particular operating procedure or technology over the long run, then these procedures likely yield benefits in excess of costs. Surviving firms continue to live by selling goods and services at lower cost and/or higher quality. A firm cannot survive by making more mistakes then its competition. Firms must add value to their customers lives by selling them competitive products. Socialism: Economic Darwinism will collapse the system. Therefore, resources should be distributed to prevent the uprising of the workers and the collapse of civil society. From each according to his ability to each according to his needs. (Marx) 55 56. What Ethics Is Not in the US Feelings: Ethics should not be the same as feelings. An individuals feelings about what is right or wrong do not ensure an ethical decision. While some individuals will feel bad when they have done something wrong, others may not. Ethical decisions are often difficult precisely because the wrong decision feels more desirable (i.e. is easier). Religion: Ethics is not merely religion. Although most if not all religions present a set of ethical standards. Many people are not religious, but ethics applies to everyone. Most religions do advocate high ethical standards but sometimes do not address all the types of problems we face. Law: Ethics is not merely following the law, a good system of law does incorporate many ethical standards, but law can deviate from what is ethical. 56 57. What Ethics Is Not in the US Government: Governments can become ethically corrupt such as totalitarian regimes. The government can be a function of power and designed to serve the interests of narrow special interest groups. Culture: Ethics is not merely following culturally accepted norms. Some cultures are quite ethical, but others become corruptor blindto certain ethical concerns (such as Nazi Germany). When in Rome, do as the Romans do is not a satisfactory ethical standard. On the other hand, it is advisable to be aware of and sensitive to cultural norms when entering other environments. 57 58. Objective 4 Review information ethics and explain the necessity of ethical conduct for the accounting profession. 58 59. Introduction Handling information responsibly means understanding the following issues: Ethics Personal privacy Threats against information Protection of information 59 60. 60 Special Need for Ethical Conduct in Professions Professionals are held to a higher standard that most others in a society. Professionals are expected to maintain the public trust. Therefore, professionals need to conduct themselves in a highly ethical manner to maintain the trust of the public. 61. Accounting Ethics Accounting ethics is primarily a field of applied ethics, the study of moral values and judgments as they apply to the profession of accountancy. Accounting ethics were first introduced by Luca Pacioli, and later expanded by governmental groups and professional organizations. Due to the diverse range of accounting services and recent corporate collapses, attention has been drawn to ethical standards accepted within the accounting profession. To combat the criticism and prevent fraudulent accounting, various accounting organizations and governments have developed regulations and remedies for improved ethical behavior among the accounting profession. 61 62. Accounting Ethics Protect Investors The nature of the work carried out by accountants and auditors requires a high level of ethics. Shareholders, potential shareholders, and other users of the financial statements rely heavily on the yearly financial statements of a company as they can use this information to make an informed decision about investments. Knowledge of ethics can help accountants and auditors to overcome ethical dilemmas, allowing for the right choice that, although it may not benefit the company, will benefit the public who relies on the accountant/auditor's reports. 62 63. 63 Policies and Systems that Encourage Accountants to Remain Professional CPA Examination GAAS and Interpretations Continuing Education Requirements Quality Control Peer Review Legal Liability PCAOB and SEC AICPA Practice and Quality Centers Code of Professional Conduct 64. Objective 5 Resolve ethical dilemmas using the Frame, Analyze and Communicate (FACt) approach and consider decision making steps for ethical choices. 64 65. Factors that Determine How You Decide Ethical Issues Actions in ethical dilemmas are determined by: Your basic ethical structure The circumstances of the situation Your basic ethical structure determines what you consider to be: Minor ethical violations Serious ethical violations Very serious ethical violations 65 66. Help for Ethical Dilemmas Talk to someone whose judgment you trust. Visit companys ethical ombudsman. Ask many questions about what you are being asked to do (frame the questions in terms of companys, employees, customers, investors and societys best interest). You may have to refuse to do something you consider unethical. 66 67. 67 Step by Step Approach to Resolving Ethical Dilemmas applied within the FACt Approach. A. Frame 1. Identify the ethical issue. 2. Gather the relevant facts surrounding the issue. 3. Determine which parties are affected. B. Analyze 4. Identify the solutions to the issue. 5. Identify the likely consequence of each potential solution. 6. Analyze and question the various solutions and consequences, seek advice (Socratic Method). A. Communicate 7. Decide and take the appropriate action on the solutions selected. 8. Reflect on the results to improve future ethical decision making. Source: Brickley and Posavac, 2005. 68. Objective 6 Examine the nature of fraud and white collar crime. 68 69. Introduction Information systems are becoming increasingly more complex and society is becoming increasingly more dependent on these systems. Companies also face a growing risk of these systems being compromised. Recent surveys indicate 67% of companies suffered a security breach in the last year with almost 60% reporting financial losses. 69 70. Fraud Definition Fraud is any and all means a person uses to gain an unfair advantage over another person. In most cases, to be considered fraudulent, an act must involve: A false statement (oral or in writing) About a material fact Knowledge that the statement was false when it was uttered (which implies an intent to deceive) A victim relies on the statement And suffers injury or loss as a result 70 71. Fraud: Civil vs. Criminal The definition is the same whether it is a criminal or civil fraud case. The only difference is the burden of proof required. Criminal case: Beyond a reasonable doubt. Civil case: Preponderance of the evidence or clear and convincing evidence. 71 72. The Fraud Process Since fraudsters dont record their frauds, we can only estimate the amount of losses: The Association of Certified Fraud Examiners (ACFE) estimates that total fraud losses in the U.S. run around 5% of annual GDP or almost $1 trillion in 2014. More than we spend on education and roads in a year. 6 times what we pay for the criminal justice system. Income tax fraud is estimated to be over $400 billion per year. Fraud in the healthcare industry is estimated to exceed $100 billion a year. Identity fraud cost the US economy over $25 billion a year. 72 73. The Fraud Process Fraud against companies may be committed by an employee or an external party. Former and current employees (called knowledgeable insiders) are much more likely than non-employees to perpetrate frauds against companies. Wells (2001) surveyed 12,000 employees, and 33% reported that they stole company money or property. The majority of fraud is detected by way of tips (43.3%) as opposed to management reviews (14.6%) or audits (14.4%). Also fraud occurs a median of 18 months before detection (ACFE, 2012). 73 74. The Fraud Process Fraud perpetrators are often referred to as white-collar criminals. Distinguishes them from violent criminals, although some white-collar crime can ultimately have violent outcomes, such as: Perpetrators or their victims committing suicide. Healthcare patients killed because of alteration of information, etc., that can result in their deaths. 74 75. Types of Frauds OCCUPATIONAL Fraudulent Statements Financial Non-financial Asset Misappropriation Theft of Cash Fraudulent disbursements Inventory and other assets Bribery and Corruption Bribery Illegal gratuities Economic extortion Conflict of interest OTHER Intellectual property theft Financial institution fraud Check and credit card fraud Insurance fraud Healthcare fraud Bankruptcy fraud Tax fraud Securities fraud Money laundering Consumer fraud Computer and Internet fraud 75 76. Misappropriation of Assets Three types of occupational fraud: Misappropriation of assets Involves theft, embezzlement, or misuse of company assets for personal gain. Examples include billing schemes, check tampering, skimming, and theft of inventory. In a recent Report to the Nation on Occupational Fraud and Abuse, 92.7% of occupational frauds involved asset misappropriation at a median cost of $93,000. 76 77. Corruption Three types of occupational fraud: Misappropriation of assets Corruption Corruption involves the wrongful use of a position to procure a benefit that is contrary to the responsibilities of that position. Examples include kickback schemes and conflict of interest schemes. About 30.1% of occupational frauds include corruption schemes at a median cost of $250,000. 77 78. Fraudulent Statements Three types of occupational fraud: Misappropriation of assets Corruption Fraudulent statements Financial statement fraud involves misstating the financial condition of an entity by intentionally misstating amounts or disclosures in order to deceive users. About 7.9% of occupational frauds involve fraudulent statements at a median cost of $1 million. The median pales in comparison to the maximum cost which can be billions. 78 79. Fraudulent Statements The National Commission on Fraudulent Financial Reporting (the Treadway Commission) defined fraudulent financial reporting as intentional or reckless conduct, whether by act or omission, that results in materially misleading financial statements. Financial statements can be falsified to: Deceive investors and creditors Cause a companys stock price to rise Meet cash flow needs Hide company losses and problems 79 80. Fraudulent Statements Fraudulent financial reporting is of great concern to independent auditors, because undetected frauds lead to half of the lawsuits against auditors. In the case of Enron, a financial statement fraud led to the total elimination of Arthur Andersen, a top international public accounting firm. 80 81. The Fraud Process Common approaches to cooking the books include: Recording fictitious revenues Recording revenues prematurely Recording expenses in later periods Overstating inventories or fixed assets (WorldCom) Concealing losses and liabilities 81 82. Agency Theory An agent (employee) is hired to act on behalf of the principal (owner, stockholder, voter, etc). The principal-agent problem arises when a principal compensates an agent for working on behalf of the principal and the elements of performance are costly to measure. Ensuring appropriate incentives involves changing the rules of the game so that the self-interested rational choices of the agent coincide with what the principal desires. Doing this in practice results in a multitude of compensation mechanisms (the carrot, bonuses, stock options, profit sharing, salary raises, promotions, etc...) and supervisory schemes (the stick, demotion, employment termination, negative review, pay cuts, etc). Increase incentives to perform and decrease incentives to steal. 82 83. Organizations as a Nexus of Contracts If organizations are viewed as a nexus of contracts between agents and principals then management systems must supply information to principals that monitor and enforce their contractual relationships with agents. The contracts could be with external or internal organizations and individuals. Organizations must have clear hierarchies of reporting and responsibility. Internal controls are systems that hope to enforce these contractual obligations. 83 84. Objective 7 Discuss who commits fraud and the reasons why. 84 85. Who Commits Fraud and Why Researchers have compared the psychological and demographic characteristics of three groups of people: White-collar criminals Violent criminals The general public They found: Significant differences between violent and white-collar criminals. Few differences between white-collar criminals and the general public. 85 86. Who Commits Fraud and Why White-collar criminals tend to mirror the general public in: Education Age Religion Marriage Length of employment Psychological makeup 86 87. Who Commits Fraud and Why Perpetrators (perps.) of computer fraud tend to be younger and possess more computer knowledge, experience, and skills. Hackers and computer fraud perps. tend to be more motivated by: Curiosity A quest for knowledge The desire to learn how things work The challenge of beating the system Gain stature in the hacking community 87 88. Who Commits Fraud and Why Criminologist Donald Cressey, interviewed 200+ convicted white-collar criminals in an attempt to determine the common threads in their crimes. As a result of his research, he determined that three factors were present in the commission of each crime. These three factors have come to be known as the fraud triangle. Pressure Opportunity Rationalization 88 89. The Fraud Triangle Donald Cressey Pressure Opportunity Rationalization 89 90. Extended Fraud Triangle (Romney and Steinbart) 90 91. Fraud Rationalizations Rationalizations of fraud take many forms, including: I was just borrowing the money. It wasnt really hurting anyone. (Corporations are often seen as non-persons, therefore crimes against them are not hurting anyone.) Everybody does it. Ive worked for them for 35 years and been underpaid all that time. I wasnt stealing; I was only taking what was owed to me. I didnt take it for myself. I needed it to pay my childs medical bills. 91 92. Who Commits Fraud and Why Pressure Cressey referred to this pressure as a perceived non-shareable need. The pressure could be related to finances, emotions, lifestyle, or some combination. 92 93. Who Commits Fraud and Why The most common pressures were: Not being able to pay ones debts, nor admit it to ones employer, family, or friends (which makes it non- shareable) May be associated with vices, such as drugs, gambling, mistresses, etc. 93 94. Who Commits Fraud and Why The most common pressures were: Fear of loss of status because of a personal failure Business reversals Example would be mismanagement of a personal investment or retirement fund. Not many people can walk away from a failing business. 94 95. Who Commits Fraud and Why The most common pressures were: Physical isolation When an individual is isolated, physically or psychologically, almost any pressure becomes non- shareable. 95 96. Who Commits Fraud and Why The most common pressures were: Status gaining Many frauds are motivated by nothing more than a perceived need to keep up with the Joneses. The problem is that there is always a richer Jones down the street and the pressure continues to mount, as do the resulting thefts. 96 97. Who Commits Fraud and Why The most common pressures were: Difficulties in employer-employee relations May create pressure to get revenge, take the money you feel is rightfully owed to you, etc. 97 98. Who Commits Fraud and Why In the case of financial statement frauds, common pressures include: To prop up earnings or stock price so that management can: Receive performance-related compensation. Preserve or improve personal wealth held in company stock or stock options. Keep their jobs. To cover the inability to generate cash flow. To obtain financing. To appear to comply with bond covenants or other agreements. May be opposite of propping up earnings in cases involving income-tax motivations, government contracts, or regulation. 98 99. Who Commits Fraud and Why Opportunity is the opening or gateway that allows an individual to: Commit the fraud Conceal the fraud Convert the proceeds 99 100. Who Commits Fraud and Why Concealing the fraud often takes more time and effort and leaves more evidence than the actual theft or misrepresentation. Examples of concealment efforts: Charge a stolen asset to an expense account or to an account receivable that is about to be written off. Create a ghost employee who receives an extra paycheck. 100 101. Lapping Examples of concealment efforts: Lapping Steal a payment from Customer A. Apply Customer Bs payment to Customer As account so Customer A wont get a late notice. Apply Customer Cs payment to Customer Bs account, so Customer B wont get a late notice, etc. 101 102. Kitting Kiting (playing the float, paper hanging): Creates cash by transferring money between banks. Requires multiple bank accounts. Basic scheme: Write a check on the account of Bank A. Bank A doesnt have sufficient funds to cover the check, so write a check from an account in Bank B to be deposited in Bank A. Bank B doesnt have sufficient funds to cover the check, so write a check from an account in Bank C to be deposited in Bank B, etc 102 103. Ponzi Scheme A fraudulent investment operation that pays returns to investors from their own money or money paid by subsequent investors, rather than from any actual profit earned. The Ponzi scheme usually entices new investors by offering returns other investments cannot guarantee, either abnormally high or unusually consistent. The perpetuation of the returns requires an ever-increasing flow of money from investors to keep the scheme going. The system is destined to collapse because the earnings, if any, are less than the payments to investors. The scheme is named after Charles Ponzi, who became notorious for using the technique in early 1920. Ponzi did not invent the scheme, Charles Dickens 1857 novel Little Dorrit described such a scheme decades before Ponzi was born. 103 104. Money Laundering Money laundering is the process of changing large amounts of money obtained from crimes, such as drug trafficking, into funds that appears to have originated from a legitimate source such as a business. This method allows the criminals involved to claim the money is legitimate, pay taxes on it, and spend it. 104 105. Converting Proceeds Unless the target of the theft is cash, then the stolen goods must be converted to cash or some form that is beneficial to the perpetrator. Checks can be converted through alterations, forged endorsements, etc Non-cash assets can be sold (online auctions are a favorite forum) or returned to the company for cash. 105 106. Opportunities that Permit Fraud Internal Control Factors Failure to enforce/monitor internal controls Management not involved in control system Management override of controls and guidelines Ineffective oversight by board of directors No effective internal auditing staff Infrequent third-party reviews Insufficient separation of authorization, custody, and record-keeping duties Unclear lines of authority 106 107. Opportunities that Permit Fraud Other Factors Large, unusual, or complex transactions Numerous adjusting entries at year end Related-party transactions Accounting department understaffed and overworked Incompetent personnel Rapid turnover of key employees Frequently changing auditors, legal counsel 107 108. The Fraud Management Wheel Like the Fraud Triangle, the purpose of the Fraud Management Wheel (the Wheel) is to organize psychological models as they relate to fraud in a logical and visual representation. We (Tribunella, Friedman, Cizmeli, Tribunella, 2014) hope that the Wheel will depict a richer prospective on fraud, display concepts that are conceptually absent from models such the Fraud Triangle, provide a framework for understanding fraud, and suggest future research that links psychological theory with fraud. Fraud does not occur in a vacuum, it manifests itself in a specific macro-level context. Accordingly, the outer most circle of the Wheel suggests that fraud occurs within economic, social and technological contexts. 108 109. 109 Risky Shift, Group Think, ResponsibilityDiffusion Justice, Rewards, Leadership, Controls, HR Management Individual Group Organization Fraud Management M oralDevelopm ent, Cognitive Dissonance,Expectancy, Equity,Risk Propensity,Prospect 110. The Wheel: Macro-Level Context Economic: During favorable economic conditions characterized by growth and solid economic returns, there may be less perceived motivation to commit fraud as individuals receive generous rewards (given a pay for performance reward program). Social: Refers to societal norms, politics, and cultures, both national and organizational. For example, bribes are considered unlawful with heavy sanctions in some areas of the world yet considered a relatively acceptable normal way of doing business in other areas (World Bank, 2013). Technological: Refers to the role of technology in fraud. Technology is a double-edge sword. Technology can be used to prevent and detect fraud with various techniques, but technology can also be used to commit fraud, such as phishing and hacking. 110 111. Psychological Theories: Individual Level Cognitive Dissonance: A theory developed by Festinger (1957) that individuals experience a feeling of discomfort after they perform an action that is deviant behavior from their self- concept. They try to reduce the feeling of discomfort by (1) changing their deviant behavior, and/or (2) attempting to justify their deviant behavior. Moral Development: The decision-maker's moral development level may be a moderating variable. Individuals moral reasoning, the basis for acting ethically, develops in a predictable sequence of six stages: (1) obedience and punishment, (2) self-interest, (3) conformity, (4) social order, law and authority, (5) social contract orientation, and (6) universal ethical principles (Kohlberg, 1973, 2008). 111 112. Psychological Theories: Individual Level Expectancy Theory: States that motivation is a function of the perceived probability that effort will result in performance (effort to performance expectancy, or E-P), that performance will result in certain outcomes (performance to outcome expectancy, or P-O), and that these outcomes are valued, (Issac, Wilfred, & Douglas, 2001; Porter & Lawler, 1968; Vroom, 1964). Equity Theory: Addresses how individuals process information and determine the extent to which they are treated fairly at work (Adams, 1963). The vast majority of research on Equity theory deals with perceptions of pay fairness. 112 113. Psychological Theories: Individual Level Risky Decision-Making: Under what circumstances are individuals more likely to make risky decisions? Two relevant theories follow: Risk Propensity: Individuals' propensity for risk vary. A decision maker that is willing to take more risk establishes objectives, evaluates alternatives, and selects alternatives differently than individuals who are more risk averse (Ivanevich et al, 2013). Prospect Theory: When individuals are faced with making a risky decision, they do not process their alternatives in the same way. Kahneman and Tversky (1979) introduced Prospect Theory to address this issue. Accordingly, people value gains and losses differently. If people are given two equal choices, one communicated in terms of possible gains and the other in possible losses, even though the two choices are equal, people will be more likely to choose the gains. Therefore, most people are risk adverse. 113 114. Psychological Theories: Group Level Groups: Decision-making literature suggests that in general groups make better decisions if they rely on the person with the most expertise and if group members are motivated by group interests rather than their self- interests (De Dreu, Nijstad, & van Knippenberg, 2008). When these conditions are not met, groups can make worse decisions. Risky Shift: Occurs when a group collectively agrees on a course of action that is more extreme than they would have made if asked individually. Empirical evidence also suggests that groups tend to make riskier decisions than individuals (Janis, 1982). 114 115. Psychological Theories: Group Level Groupthink: Janis (1982) defines groupthink as a kind of thinking in which group members are mainly motivated to maintain group cohesiveness rather than making better or more realist decisions. Responsibility Diffusion: Group members may experience de-individuation and a diffusion of responsibility for their deviant behaviors. This may result in an illusory perception of being not personally accountable for fraudulent behavior based on the assumption that it will be the groups fault if the fraudulent behavior is discovered. 115 116. Psychological Theories: Organizational Level Organizational Justice and Rewards: Are concerned with the ways in which employees determine if they have been treated fairly in their jobs and the ways in which those determinations influence other work-related variables (Moorman, 1991, p. 845). Leadership: Research with respect to corporate governance, Man & Wong (2013) found that board independence can increase external monitoring of managerial fraudulent activities such as misappropriation of funds, and that female directors can better develop trust leadership, open communications, and transparency. Bhal and Dadhich (2011) found that ethical leadership can encourage whistle blowing. Huberts, Kaptein, and Lasthuizen (2007, p. 587) found that employees appear to copy the leaders integrity standards in their daily interaction with one another. 116 117. Objective 8 Review computer fraud and abuse techniques. 117 118. Computer Fraud The U.S. Department of Justice defines computer fraud as any illegal act for which knowledge of computer technology is essential for its: Perpetration; Investigation; or Prosecution. 118 119. Computer Fraud Many computer frauds go undetected. An estimated 80-90% of frauds that are uncovered are not reported because of fear of: Adverse publicity Copycats Loss of customer confidence. There are a growing number of competent computer users, and they are aided by easier access to remote computers through the Internet and other data networks. 119 120. Hacker Rationalizations Creators of worms and viruses often use rationalizations like: The malicious code helped expose security flaws, so I did a good service. It was an accident. It was not my faultjust an experiment that went bad. It was the users fault because they didnt keep their security up to date. If the code didnt alter or delete any of their files, then whats the problem? 120 121. Computer Fraud Economic Espionage Economic espionage, the theft of information and intellectual property, is growing especially fast. Government as well as organizations are the target. This growth has led to the need for investigative specialists or cyber-sleuths. In some case cyber-war is conducted. 121 122. Computer Viruses Perpetrators have devised many methods to commit computer fraud and abuse. These include computer viruses. Many viruses have two phases: First, when some predefined event occurs, the virus replicates itself and spreads to other systems or files. Another event triggers the attack phase in which the virus carries out its mission. A virus may lay dormant or propagate itself without causing damage for an extended period. 122 123. Computer Worms A worm is similar to a virus except for: A worm is a stand-alone program, while a virus is only a segment of code hidden in a host program or executable file. A worm will replicate itself automatically, while a virus requires a human to do something like open a file. Worms often reproduce by mailing themselves to the recipients mailing list. They are not confined to PCs and have infected cell phones in Japan. A worm typically has a short but very destructive life. It takes little technical knowledge to create worms or viruses; several websites provide instructions. Most exploit known software vulnerabilities that can be corrected with a software patch, making it important to install all patches as soon as they are available. 123 124. Denial of Service Attack Denial of service attacks Experts estimate there as many as 5,000 denial-of- service attacks weekly in the U.S. A denial-of-service can cause severe economic damage to its victim or even drive them out of business. An attacker overloads and shuts down an Internet Service Providers email system by sending email bombs at a rate of thousands per secondoften from randomly generated email addresses. May also involve shutting down a web server by sending a load of requests for the web pages. 124 125. Phishing Phishing is a form of social engineering with three stages: bait, hook and boat. Perpetrator sends out many email, instant, or text messages. The message asks the victim to send financial information, passwords, or click-through to a site that collects the information. The perp. tries to deceive the victim into thinking they are a legitimate source. 125 126. Phishing For example, phishers have impersonated the IRS. The phisher told victims they had a refund (bait). Victims were told to go to a Web site to make a claim (hook). Once there, the site asked for financial information such as passwords and bank account numbers (boat). 126 127. Objective 9 Provide an overview of the AICPA Ethics Codification Project 127 128. AICPA Ethics Codification Project Project was undertaken to make using the code more intuitive and easy for members. The code has been restructured by topic and placed online with a platform that allows for searches, email links, bookmarks and notes. Also included in the code are pop-ups for defined terms and hyperlinks that connect relevant portions of the code together. Nonauthoritative Guidance is included at the end of the applicable topic or section of the code. 128 129. Changes to the code Most of the code remains the same. Certain language was changed for consistency. Certain provisions were updated to reflect the conceptual frameworks. Certain nonauthoritative guidance was included. 129 130. Old Code vs. New Code To easily find guidance from the previous code in the new updated code you can use the AICPAs mapping document which can be downloaded at: http://www.aicpa.org/InterestAreas/ProfessionalEthi 130 131. AICPAs Mapping Document 131 132. Frameworks The Project also added two frameworks to the code: Conceptual Framework for Members in Public Practice and Conceptual Framework for Members in Business. The frameworks can be used where there is a lack of guidance on a particular relationship or circumstance. The previous Conceptual Framework for independence has been retained in the new code. 132 133. Effective Dates The new AICPA Code of Professional Conduct is effective December 15, 2014. Early implementation is permitted. The Conceptual Frameworks and related interpretations will be effective December 15, 2015. 133 134. Information on the Project http://www.aicpa.org/InterestAreas/Professional Ethics/Community/Pages/aicpa-ethics- codification-project.aspx 134 135. Location of Current Code 135 http://www.aicpa.org/Research/Standards/CodeofConduct/Pages/default.as px 136. Location of Online Code 136 http://pub.aicpa.org/codeofconduct/Ethics.aspx 137. Objective 10 Show the organization of topics in the code of Professional Conduct. 137 138. Parts of the code Preface: Applicable to All Members Part 1: Members in Public Practice Part 2: Members in Business Part 3: Other Members 138 139. Preface: Applicable to All Members 0.100 Overview of the Code of Professional Conduct 0.200 Structure and Application of the AICPA Code 0.300 Principles of Professional Conduct 0.400 Definition 0.500 Nonauthoritative Guidance 0.600 New, Revised, and Pending Interpretations and Other Guidance. 139 140. Part 1: Members in Public Practice 1.000 Introduction 1.100 Integrity and Objectivity 1.200 Independence 1.300 General Standards 1.400 Acts Discreditable 1.500 Fees and Other Types of Renumeration 1.600 Advertising and Other Forms of Solicitation 1.700 Confidential Information 1.800 Form of Organization and Name 140 141. Part 2: Members in Business 2.000 Introduction 2.100 Integrity and Objectivity 2.300 General Standards 2.400 Acts Discreditable 141 142. Part 3: Other Members 3.000 Introduction 3.400 Acts Discreditable 142 143. Objective 11 Review the conceptual framework for members in public practice 143 144. Conceptual Framework for Members in Public Practice Located at 1.000.010 in the code. Utilizes a threats and safeguard approach. Applies when there is no guidance in the code. Cannot be used to override existing rules and interpretations of the code. Effective December 15, 2015, early implementation is allowed provided the member has implemented the revised code. 144 145. Definitions Acceptable level A level at which a reasonable and informed third party who is aware of the relevant information would be expected to conclude that a members compliance with the rules is not compromised. Safeguards Actions or other measures that may eliminate a threat or reduce a threat to an acceptable level. Threats Relationships or circumstances that could compromise a members compliance with the rules. 145 AICPA Code of Professional conduct 1.000.010.04-.06 146. Conceptual Framework Approach 1. Identify threats 2. Evaluate the significance of a threat. 3. Identify and apply safeguards 146AICPA Code of Professional Conduct 1.000.010.07 147. Types of Threats Adverse interest threat the threat that a member will not act with objectivity because the members interests are opposed to the clients interests. Advocacy threat the threat that a member will promote a clients interest or position to the point that his or her objectivity or independence is compromised. Familiarity threat The threat that, due to a long or close relationship with a client, a member will become too sympathetic to the clients interests or too accepting of the clients work or product. 147 AICPA Code of Professional Conduct 1.000.010.10-.12 148. Types of Threats Management participation threat the threat that a member will take on the role of client management or otherwise assume management responsibilities, such may occur during an engagement to provide nonattest services. Self-interest threat the threat that a member could benefit, financially or otherwise, from an interest in, or relationship with, a client or persons associated with the client. 148AICPA Code of Professional Conduct 1.000.010.13-.14 149. Types of Threats Self-review threat the threat that a member will not appropriately evaluate the results of a previous judgment made or service performed or supervised by the member or an individual in the members firm and that the member will rely on that service in forming a judgment as part of another service. Undue influence threat the threat that a member will subordinate his or her judgment to an individual associated with a client or any relevant third party due to that individuals reputation or expertise, aggressive or dominate personality, or attempts to coerce or exercise excessive influence over the member. 149 AICPA Code of Professional Conduct 1.000.010.15-.16 150. Categories of Safeguards 1. Safeguards created by the profession legislation or regulation. 2. Safeguards implemented by the client (cannot not rely solely on) 3. Safeguards implemented by the firm, including policies and procedures to implement professional and regulatory requirements. 150AICPA Code of Professional Conduct 1.000.010.18 151. Examples of profession, legislation or regulation safeguards 1. Education and training requirements on independence and ethics rules. 2. Continuing education requirements on independence and ethics. 3. Professional standards and threat of discipline. 4. External review of a firms quality control system. 5. Legislation establishing prohibitions and requirements for a firm or a firms professional employees. 6. Competency and experience requirements for professional licensure. 7. Professional resources, such as hotlines, for consultation on ethical issues. 151 AICPA Code of Professional Conduct 1.000.010.21 152. Examples of client safeguards 1. Client has personnel with suitable skill, knowledge, or experience who make managerial decisions about the delivery of professional services and makes use of third- party resources for consultation as needed. 2. The tone at the top emphasizes the clients commitment to fair financial reporting and compliance with the applicable laws, rules, regulations, and corporate governance policies. 3. Policies and procedures are in place to achieve fair financial reporting and compliance with applicable laws, rules, regulations, and corporate governance policies. 4. Policies and procedures are in place to address ethical conduct. 152 AICPA Code of Professional Conduct 1.000.010.22 153. Examples of client safeguards 5. A governance structure, such as an active audit committee, is in place to ensure appropriate decision making, oversight, and communications regarding a firms services. 6. Policies are in place that bar the entity from hiring a firm to provide services that do not serve the public interest or that would cause the firms independence or objectivity to be considered impaired. 153AICPA Code of Professional Conduct 1.000.010.22 154. Examples of firm safeguards Firm leadership that stresses the importance of complying with the rules Policies and procedures related to engagement quality control Policies and procedures that identify interests/relationships between the firm, partners, professional staff and clients Training on firms policies and procedures Disciplinary mechanism that is designed to promote compliance with policies and procedures. 154 AICPA Code of Professional Conduct 1.000.010.23 155. Examples of firm safeguards Policies and procedures designed to empower staff to communication to senior members of the firm. Rotation of senior personnel who are part of the engagement team. Having another firm to reperform a nonattest service to the extent necessary for it to take responsibility for that service. Removal of a individual from an attest engagement team when that individual's financial interests or relationships pose a threat to independence. For more examples see AICPA Code of Professional Conduct 1.000.010.23 155 AICPA Code of Professional Conduct 1.000.010.23 156. Factors that influence the effectiveness of safeguards The facts and circumstances specific to a particular situation. The proper identification of threats. Whether the safeguard is suitably designed to meet its objectives. The party(ies) who will be subject to the safeguard. How the safeguard is applied. The consistency with which the safeguard is applied. Who applies the safeguard. How the safeguard interacts with a safeguard from another category. Whether the client is a public interest entity. 156 AICPA Code of Professional Conduct 1.000.010.19 157. Objective 12 Review the conceptual framework for independence. 157 158. Conceptual Framework for Independence Located at 1.210.010 in the code. Utilizes a threats and safeguard approach. Applies when there is no guidance in the code. Cannot be used to override existing rules and interpretations of the code. 158 159. Definitions Acceptable level A level at which a reasonable and informed third party who is aware of the relevant information would be expected to conclude that a members independence is not impaired. Impair(ed) in connection with independence, to effectively extinguish independence. When a members independence is impaired, the member is not independent. Safeguards Actions or other measures that may eliminate a threat or reduce a threat to an acceptable level. Threats Relationships or circumstances that could impair independence 159 AICPA Code of Professional conduct 1.210.010.03-.06 160. Conceptual Framework Approach Identify threats Evaluate the threat that the member would not be independent or would be perceived as not being independent. Reduce or eliminate the threat to an acceptable level to conclude the member is independent. Threats are at an acceptable level either because: 1. The types of threats and their potential effect 2. Safeguards have eliminated or reduced the threat. 160AICPA Code of Professional Conduct 1.210.010.07 161. Types of Threats Adverse interest threat the threat that a member will not act with objectivity because the members interests are opposed to the interest of an attest client. Advocacy threat the threat that a member will promote an attest clients interest or position to the point that his or her independence is compromised. Familiarity threat The threat that, because of a long or close relationship with an attest client, a member will become too sympathetic to the attest clients interests or too accepting of the attest clients work or product. 161 AICPA Code of Professional Conduct 1.000.010.12-.14 162. Types of Threats Management participation threat the threat that a member will take on the role of attest client management or otherwise assume management responsibilities for an attest client. Self-interest threat the threat that a member could benefit, financially or otherwise, from an interest in, or relationship with, an attest client or persons associated with the attest client. 162AICPA Code of Professional Conduct 1.000.010.15-.16 163. Types of Threats Self-review threat the threat that a member will not appropriately evaluate the results of a previous judgment made or service performed or supervised by the member or an individual in the members firm and that the member will rely on that service in forming a judgment as part of an attest engagement. Undue influence threat the threat that a member will subordinate his or her judgment to that of an individual associated with an attest client or any relevant third party due to that individuals reputation or expertise, aggressive or dominate personality, or attempts to coerce or exercise excessive influence over the member. 163 AICPA Code of Professional Conduct 1.000.010.17-.18 164. Categories of Safeguards 1. Safeguards created by the profession legislation or regulation. 2. Safeguards implemented by the attest client (cannot not rely solely on) 3. Safeguards implemented by the firm, including policies and procedures to implement professional and regulatory requirements. 164AICPA Code of Professional Conduct 1.000.010.20 165. Objective 13 Review the conceptual framework for members in business 165 166. Conceptual Framework for Members in Business Located at 2.000.010 in the code. Utilizes a threats and safeguard approach. Applies when there is no guidance in the code. Cannot be used to override existing rules and interpretations of the code. Effective December 15, 2015, early implementation is allowed provided the member has implemented the revised code. 166 167. Definitions Acceptable level A level at which a reasonable and informed third party who is aware of the relevant information would be expected to conclude that a members compliance with the rules is not compromised. Safeguards Actions or other measures that may eliminate a threat or reduce a threat to an acceptable level. Threats Relationships or circumstances that could compromise a members compliance with the rules. 167 AICPA Code of Professional conduct 2.000.010.03-.05 168. Conceptual Framework Approach 1. Identify threats 2. Evaluate the significance of a threat. 3. Identify and apply safeguards 168AICPA Code of Professional Conduct 2.000.010.06 169. Types of Threats Adverse interest threat the threat that a member will not act with objectivity because the members interests are opposed to the interests of the employing organization. Advocacy threat the threat that a member will promote an employing organizations interest or position to the point that his or her objectivity is compromised. Familiarity threat The threat that, due to a long or close relationship with a person or an employing organization, a member will become too sympathetic to their interests or too accepting of the persons work or employing organizations product or service. 169 AICPA Code of Professional Conduct 2.000.010.09-.11 170. Types of Threats Self-interest threat the threat that a member could benefit, financially or otherwise, from an interest in, or relationship with, the employing organization or persons associated with the employing organization. Self-review threat the threat that a member will not appropriately evaluate the results of a previous judgment made or service performed or supervised by the member or an individual in the employing organization and that the member will rely on that service in forming a judgment as part of another service. 170AICPA Code of Professional Conduct 2.000.010.12-.13 171. Types of Threats Undue influence threat the threat that a member will subordinate his or her judgment to an individual associated with the employing organization or any relevant third party due to that individuals position, reputation or expertise, aggressive or dominate personality, or attempts to coerce or exercise excessive influence over the member. 171 AICPA Code of Professional Conduct 2.000.010.14 172. Categories of Safeguards 1. Safeguards created by the profession legislation or regulation. 2. Safeguards implemented by the employing organization. 172AICPA Code of Professional Conduct 2.000.010.16 173. Examples of profession, legislation or regulation safeguards 1. Education and training requirements on ethics and professional responsibilities. 2. Continuing education requirements on ethics. 3. Professional standards and threat of discipline. 4. Legislation establishing prohibitions and requirements for entities and employees. 5. Competency and experience requirements for professional licensure. 6. Professional resources, such as hotlines, for consultation on ethical issues. 173 AICPA Code of Professional Conduct 2.000.010.19 174. Examples of employing organization safeguards Tone at the top emphasizing a commitment to fair financial reporting. Tone at the top emphasizing compliance with applicable laws, rules, regulations, and corporate governance policies. Audit committee charter, including independent audit committee members. Internal policies and procedures related to purchasing controls. Internal policies and procedures related to customer acceptance or credit limits. 174 AICPA Code of Professional Conduct 2.000.010.20 175. Examples of employing organization safeguards Human resource policies and procedures stressing the hiring and retention of technically competent employees Policies and procedures for implementing and monitoring ethical policies. Policies segregating personal assets from company assets. Staff training on applicable laws, rules, and regulations. For more examples see AICPA Code of Professional Conduct 2.000.010.20 175 AICPA Code of Professional Conduct 2.000.010.20 176. Factors that influence the effectiveness of safeguards The facts and circumstances specific to a particular situation. The proper identification of threats. Whether the safeguard is suitably designed to meet its objectives. The party(ies) who will be subject to the safeguard. How the safeguard is applied. The consistency with which the safeguard is applied. Who applies the safeguard. How the safeguard interacts with a safeguard from another category. Whether the employing organization is a public interest entity. 176 AICPA Code of Professional Conduct 2.000.010.17 177. Objective 14 Review the rules and interpretations applicable to members in business 177 178. 2.100.001 Integrity and Objectivity Rule In the performance of any professional service, a member shall maintain objectivity and integrity, shall be free of conflicts of interest and shall not knowingly misrepresent facts or subordinate his or her judgment to others. 178 AICPA Code of Professional Conduct 2.100.001 179. Interpretations of Integrity and Objectivity Rule: Application of Conceptual Framework A member is considered in violation of the rule if the member cannot demonstrate that safeguards were applied that eliminated or reduced significant threats to an acceptable level. A member should consider the guidance in Ethical Conflicts (see next slide) In absences of an interpretation, the member should refer to the conceptual framework for members in business. 179 AICPA Code of Professional Conduct 2.100.005.01-.03 180. Interpretations of Integrity and Objectivity Rule: Ethical Conflicts A member may be required to take steps to best achieve compliance with the rules and law. Members should consider the following factors: Relevant facts and circumstances, including applicable rules, laws, or regulations Ethical issues involved Established internal procedures. 180AICPA Code of Professional Conduct 2.000.020.02 181. Interpretations of Integrity and Objectivity Rule: Ethical Conflicts Member should be prepared to justify departures from rules and laws. May have to address consequences for violating such rules and laws. Should consider consulting with appropriate persons within the employing organization before taking action. If deciding not to consult with someone in the organization, should consider consulting with other individuals, professional bodies or legal counsel. Should consider documenting the substance of the issues, the parties discussed with, details of the discussions and decisions made. If the issues is still unresolved, the member will most likely be in violation of one or more rules and should consider his or her continuing relationship with the specific assignment or employer. 181 AICPA Code of Professional Conduct 2.000.020.03-.06 182. Interpretations of Integrity and Objectivity Rule: Offering or Accepting Gifts or Entertainment When accepting gifts or entertainment from a vendor or customer of the members employer the following threats may exist: Self-interest Familiarity Undue influence 182 AICPA Code of Professional Conduct 2.120.010.02 183. Cases When Threats could not be reduced to an acceptable level The acceptance of gifts or entertainment violate applicable laws, rules, or regulations or policies of the employer, vendor or customer. The member knows of the violations or demonstrates recklessness in not knowing. The gifts/entertainment is not reasonable. 183 AICPA Code of Professional Conduct 2.120.010.03 & .05 184. Reasonableness of gifts/entertainment Threats are considered at an acceptable level when the gifts/entertainment is reasonable. Member should consider the following facts and circumstances: The nature of the gift or entertainment The occasion giving rise to the gift or entertainment The cost or value of the gift or entertainment The nature, frequency, and value of other gifts or entertainment offered or accepted. Whether the entertainment was associated with the active conduct of business directly before, during or after the entertainment Whether other customers or vendors participated in the entertainment. The individuals from the customer or vendor and a members employer who participated in the entertainment. 184 AICPA Code of Professional Conduct 2.120.010.04 185. Interpretations of Integrity and Objectivity Rule: Knowing Misrepresentations in the Preparation of Financial Statements or Records Threats could not be reduced to an acceptable level through the use of safeguards if the member: Makes, or permits or directs another to make, materially false and misleading entries in an entitys financial statements or records. Fails to correct an entitys financial statements or records that are materially false and misleading when the member has the authority to record the entries; or Signs, or permits or directs another to sign, a document containing materially false and misleading information. 185AICPA Code of Professional Conduct 2.130.010.01 186. Interpretations of Integrity and Objectivity Rule: Subordination of Judgment Self-interest, familiarity and undue influence threats may exist when there is a difference of opinion on professional standards between the member and another person within the organization. Member needs to evaluate if the threats are at an acceptable level, if not, safeguards need to be applied. Threats are considered at an acceptable level if the position taken does not result in a failure to comply with professional standards, a material misrepresentation of a fact or a violation of laws and regulations. 186 AICPA Code of Professional Conduct 2.130.020.02-.04 187. Threats at acceptable level Discuss conclusions with the person taking position. No further action required 187 AICPA Code of Professional Conduct 2.130.020.05 188. Threats not an acceptable level Member should discuss concerns with supervisor If not resolved with supervisor, should discuss concerns with the appropriate higher level of management within the organization. If appropriate action was not taken the following safeguards should be applied: Determine if the organizations internal policies and procedures have additional reporting requirements for differences of opinion. Determine requirements for reporting to third parties. Consult with legal counsel Document his or her understanding of the facts, professional standards/laws/regulations and conversations and parties included in the discussions. 188 AICPA Code of Professional Conduct 2.130.020.06-.08 189. Threats not an acceptable level If no safeguards can eliminate or reduce threats to an acceptable level or if appropriate action is not taken, then the member should consider the continuing relationship with the members organization and takes steps to eliminate subordination of judgment. Nothing precludes a member from resigning, but resignation does not relieve the member of responsibilities, such as disclosure to third parties. 189 AICPA Code of Professional Conduct 2.130.020.09-.10 190. 2.130.030 Obligation of a Member to His or Her Employers External Accountant When dealing with an employers external accountant, a member must be candid and not knowingly misrepresent facts or knowingly fail to disclose material facts. 190 AICPA Code of Professional Conduct 2.130.030 191. 2.160.010 Educational Services Members who perform educational services, such as teaching full or part-time at a university, teaching a continuing professional education course, or engage in research and scholarship are performing professional services and, therefore, are subject to the Integrity and Objectivity Rule. 191 AICPA Code of Professional Conduct 2.160.010 192. 2.300.001 General Standards Rule A member shall comply wit the following standards and with any interpretations thereof by bodies designated by Council. a. Professional Competence. Under take only those professional services that the member or the members firm can reasonably expect to be completed with professional competence. b. Due Professional Care. Exercise due professional care in the performance of professional services. c. Planning and Supervision. Adequately plan and supervise the performance of professional services. d. Sufficient Relevant Data. Obtain sufficient relevant data to afford a reasonable basis for conclusions or recommendations in relation to any professional services performed. 192 AICPA Code of Professional Conduct 2.300.001 193. Interpretations of the General Standards Rule: Application of the Conceptual Framework In the absence of interpretations the conceptual framework should be used. The member is in violation if you cannot demonstrate that safeguards reduced threats to an acceptable level. Should consider the guidance in Ethical Conflicts. 193 AICPA Code of Professional Conduct 2.300.005.01-.03 194. Interpretations of General Standards Rule: Competence Competence means that the member or members staff has the technical qualification to provide the service. Agreement to provide the service implies that the member is competent in that area. A member may have the knowledge, or may need to conduct additional research or consult with others to gain competence. If a member is unable to obtain sufficient competence, then the member should suggest a competent person to perform the service. 194 AICPA Code of Professional Conduct 2.300.010.01-.04 195. Interpretations of General Standards Rule: Submission of Financial Statements When a member is a stockholder, a partner, a director, an office, or an employee of an entity and, in this capacity, prepares or submits the entitys financial statements to third parties, the member should clearly communicate, preferably in writing, the members relationship to the entity and should not imply that the member is independent of the entity. 195AICPA Code of Professional Conduct 2.300.030.01 196. 2.310.001 Compliance with Standards Rule A member who performs auditing, review, compilation, management consulting, tax or other professional services shall comply with standards promulgated by bodies designated by Council. 196 AICPA Code of Professional Conduct 2.310.001 197. Designated Bodies of Council Financial Accounting Standards Advisory Board FASB GASB PCAOB IASB AICPA Committees and Boards. Auditing Standards Board Management Consulting Services Executive Committee Attestation Standards Tax Executive Committee Forensic and Valuation Services Committee Personal Financial Planning Executive Committee 197 AICPA Code of Professional Conduct Appendix A 198. Interpretations Under the Compliance with Standards Rule: Application of Conceptual Framework In the absence of an interpretation the conceptual framework should be used. The member is in violation if you cannot demonstrate that safeguards reduced threats to an acceptable level. Should consider the guidance in Ethical Conflicts. 198AICPA Code of Professional Conduct 2.310.005.01-.03 199. 2.320.001 Accounting Principles Rule A member shall not (1) express an opinion or state affirmatively that the financial statements or other financial data of any entity are presented in conformity with generally accepted accounting principles or (2) state that he or she is not aware of any material modifications that should be made to such statements or data in order for them to be in conformity with generally accepted accounting principles, if such statements or data contain any departure from an accounting principle promulgated by bodies designated by Council to establish such principles that has a material effect on the statements or data taken as a whole. If, however, the statements or data contain such a departure and the member can demonstrate that due to unusual circumstances the financial statements or data would otherwise have been misleading, the member can comply with the rule by describing the departure, its approximate effects, if practicable, and the reasons why compliance with the principle would result in a misleading statement. 199AICPA Code of Professional Conduct 2.320.001.01 200. Interpretations Under the Accounting Principles Rule: Application of Conceptual Framework In the absence of an interpretation the conceptual framework should be used. The member is in violation if you cannot demonstrate that safeguards reduced threats to an acceptable level. Should consider the guidance in Ethical Conflicts. 200 AICPA Code of Professional Conduct 2.320.005.01-.03 201. Interpretations Under the Accounting Principles Rule: Responsibility for Affirming That Financial Statements Are in Conformity With the Applicable Financial Reporting Framework May not state affirmatively that an entitys financial statements or other financial data are presented in conformity with GAAP if there is a departure from an accounting principle. Representation in a letter or other communication that the entitys financial statements are in conformity with GAAP would be considered an affirmative statement with respect to a signature 201AICPA Code of Professional Conduct 2.320.010.01 202. Interpretations Under the Accounting Principles Rule: Status of FASB, GASB, FASAB and IASB Interpretations Bodies Designated by Council: Financial Accounting Standards Advisory Board FASB GASB PCAOB IASB AICPA Committees and Boards. 202AICPA Code of Professional Conduct 2.320.020.01-03 and Appendix A 203. Interpretations Under the Accounting Principles Rule: Departures from Generally Accepted Accounting Principles Strong presumption that adherence to GAAP would result in financial statements that are not misleading. However, there may be unusual circumstances when GAAP might be misleading. In such cases, the proper accounting treatment is to apply that which will not make the financial statements misleading. Unusual circumstances is a matter of professional judgment 203 AICPA Code of Professional Conduct 2.320.030.01-02 204. Interpretations Under the Accounting Principles Rule: Financial Statements Prepared Pursuant to Financial Reporting Frameworks Other Than GAAP Financial Statements prepared based on accounting principles not designated by council is a reporting framework other than GAAP. Members reports cannot lead the users to believe that the financial statements are in accordance with GAP and must clarify the financial reporting framework used. 204 AICPA Code of Professional Conduct 2.320.040.01-.02 and .04 205. Examples of Other Financial Reporting Frameworks Financial reporting frameworks generally accepted in another country, including jurisdictional variations of IFRS such that the entitys financial statements do not meet the requirements for full compliance with IFRS, as promulgated by the IASB; Financial reporting frameworks prescribed by an agreement or contract; or Other special purpose frameworks, including statutory financial reporting provisions required by law or a U.S. or foreign governmental regulatory body to whose jurisdiction the entity is subject. 205AICPA Code of Professional Conduct 2.320.040.03 206. Multiple Choice #1 206 a. b. c. d. 0% 0%0%0% According to the professions ethical standards, which of the following events may justify a departure from a Statement of Financial Accounting Standard? Evolution of a new form of business New Legislation transaction a. No Yes b. Yes No c. Yes Yes d. No No Source: Adopted from the AICPA CPA exam 207. Acts Discreditable Rule A member shall not commit an act discreditable to the profession. 207 AICPA Code of Professional Conduct 2.400.001.01 208. Interpretations Under the Acts Discreditable Rule: Application of Conceptual Framework In the absence of an interpretation the conceptual framework should be used. The member is in violation if you cannot demonstrate that safeguards reduced threats to an acceptable level. Should consider the guidance in Ethical Conflicts. 208 AICPA Code of Professional Conduct 2.400.005.01-.03 209. Interpretations Under the Acts Discreditable Rule: 2.400.010 Discrimination and Harassment in Employment Practices 2.400.020 Solicitation or Disclosure of CPA Examination Questions and Answers 2.400.030 Failure to File a Tax Return or Pay a Tax Liability 2.400.090 False, Misleading, or Deceptive Acts in Promoting or Marketing Professional Services 209 210. Interpretations Under the Acts Discreditable Rule: Negligence in the Preparation of Financial Statements or Records A member shall be considered in violation of the Acts Discreditable Rule if the member, by virtue of his or her negligence, does any of the following: a.Makes or permits or directs another to make, materially false and misleading entries in the financial statements or records of an entity. b.Fails to correct an entitys financial statements that are materially false and misleading when the member has the author