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Ethics in Accounting > Ch 2 Ethics and Governance Scandals > Flashcards

Ch 2 Ethics and Governance Scandals Flashcards

1
Q

What is the typical pattern associated with scandals and resulting reforms?

A
  • Scandal outrages public
  • Public tolerance diminishes
  • Credibility of corporations is eroded
  • Lawmakers, regulators, directors, and professional bodies respond to restore confidence
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2
Q

What was at the heart of the Enron scandal?

A

Failure of BOD

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3
Q

What was at the heart of Arthur Andersen’s downfall?

A

An organizational culture gone awry

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4
Q

What was at the heart of the WorldCom scandal?

A

Power in hands of one man

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5
Q

What was at the heart of the subprime mortgage meltdown?

A

Greed without due diligence

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6
Q

What were three key reforms in response to all the scandals?

A
  • SOX
  • Circular 230 (new professional standards on tax preparers and advisors)
  • Dodd Frank Act
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7
Q

In 1933, why was the Glass-Steagall Act passed?

A

To control bank speculation and protect investor deposits

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8
Q

In 2010, what was the passage of the Dodd Frank Act in response to?

A

Response to subprime lending problems

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9
Q

In 1999, what did the Gramm-Leach-Bliley Act repeal?

A

Glass-Steagall Act

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10
Q

What was the stock market crash/great depression a result of?

A
  • Widespread speculation
  • Inadequate financial reporting
  • Inadequate banking controls
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11
Q

As a result of the spectacular stock market crash in 1929, the government implemented the Securities Act of 1933, the Securities Exchange Act of 1934, as well as which of the following acts:

a) Glass Steagall Act
b) Investment Advisers Act
c) Gramm-Leach-Bliley Act
d) All of the above
e) Two of the above

A

e) Two of the above (Glass Steagall and Investment Advisers Act)

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12
Q

What does the Securities Act of 1933 require from companies raising money from the public?

A
  • Register with SeC
  • Follow SEC regulations reissuing securities, providing information to investors
  • Requires audit certification by independent accountant
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13
Q

What did the Securities Exchange Act of 1934 create?

A

Created regulatory framework for trading of stocks and bonds of registered companies

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14
Q

What did the Glass-Steagall Act of 1933 separate?

A

Separates investment banks from commercial banks to prevent bank failures (i.e. to prevent commercial banks from engaging in speculative practices)

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15
Q

What did the Investment Advisers Act of 1940 create?

A

Created framework for registration and regulation of investment advisors

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16
Q

Between 1970 and 1990, what movements arose?

A
  • Environmentalism
  • Consumerism (e.g. Ralph Nader)
  • Socially responsible investing
  • Anti-bribery
  • Regulation concerning child labor, fair wages, fair trade, sweatshops
  • Corporate stakeholders
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17
Q

Name a scandal related to accounting fraud.

A
  • Aurora Foods
  • Sunbeam
  • WM
  • Adelphia
  • Xerox
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18
Q

What did AA do in 1954 that started to shift its organizational culture?

A

Expanded from providing accounting and audit services to providing consulting services (to the very same firms it was auditing)

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19
Q

True or false.

By 1984, AA’s consulting services revenue was greater than audit service revenue.

A

True

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20
Q

What was the prime motivation behind the decisions of AA’s audit partners on the Enron, WorldCom, WM, and Sunbeam audits?

A
  • Revenue generation and client retention

- Partners more interested in serving their own interest than serving the public

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21
Q

During the 1980s, how did the culture of integrity at AA change?

A
  • Revenue generation became key to promotion
  • Focus was on providing non-audit services to management
  • Pressure to reduce audit costs increased
  • Audit partners allowed to override rulings of quality control partners
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22
Q

Did the AA partner in charge challenge Enron’s accounting policies?

A

No

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23
Q

True or false.

AA was providing both audit and consulting services to Enron, and was deriving more revenue from providing management services.

A

True

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24
Q

Why should an auditor make decisions in the public interest rather than in the interest of management or current shareholders?

A

Auditors responsibility is to the public

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25
Q

Why didn’t the AA partners responsible for quality control stop the flawed decisions of the audit partners?

A
  • Tried via memos
  • But firm’s governance structure had earlier determined that audit partner in charge could override quality control partner’s decisions
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26
Q

In March of 2002, what did the SEC announce?

A

It was investigating AA for audit deficiencies w/r/t Enron audit

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27
Q

What did AA’s lawyer seem to encourage the Enron audit team to do?

A

Shredding documents

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28
Q

Should all of AA have suffered for the actions or inactions of under 100 people?

A
  • Seems unfair to many innocent partners and staff
  • Society was not well-served by loss of one of the Big 5
  • But disappearance of AA sent a clear message
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29
Q

Which of AA personnel should have been prosecuted?

A
  • Larger fine and imprisonment for AA decision makers like audit partners
  • Plus a very large fine and sanctions for continuing firm
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30
Q

How was Enron founded?

A

Founded by Ken Lay in 1985 as a result of merger of two natural gas pipeline companies

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31
Q

Although Enron’s core business was selling gas, what did it move into?

A

Energy futures market

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32
Q

How did Enron record revenues from the energy futures market?

A

Recorded revenue in current period rather than period in which gas delivered (“prepays”)

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33
Q

Were the special purpose enterprises established to invest in Enron’s capital-intensive energy projects independent of Enron?

A

No

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34
Q

What was the impact of Enron’s aggressive accounting methods?

A

Artificially inflated revenues while understating liabilities

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35
Q

What did an internal and external investigation of Enron reveal?

A

BOD failed to provide oversight and governance

  • Permitted Enron executives to not record material off the book liabilities through use of SPEs
  • Paid executive compensation to senior executives, often w/o proper approval
  • Permitted executives to engage in high risk accounting transactions and inappropriate conflicts of interest
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36
Q

True or false.

Enron BODs failed to ensure the independence of Enron’s auditor’s, AA, and chose to ignore the complaints of various whistleblowers.

A

True

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37
Q

What was the aftermath of the Enron scandal?

A
  • Tens of thousands of employees lost jobs
  • Millions of investors lost millions of dollars
  • Ten key employees indicted and sent to prison although Ken Lay died before sentencing
  • AA convicted of obstruction of justice w/i the year
  • Congress would enact SOX
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38
Q

Ken Lay was the Chair of the Board and the CEO for much of the time. How did this probably contribute to lack of proper governance?

A
  • Not an effective overseer of his own CEO actions as a good independent Chair of the Board should
  • Inherent conflict of interest
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39
Q

At Enron, why didn’t more whistleblowers come forward, and why didn’t some make a significant difference?

A
  • Fear of retaliation

- Poor tone at the top

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40
Q

At Enron, what should the internal auditors have done that might have assisted the directors?

A
  • Should have been alert for flaws in Enron’s conflict of interest policies
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41
Q

What conflict of interest situations can you identify in Enron’s SPE activities? AA’s activities? executive activities?

A

Personal gain

42
Q

How would you characterize Enron’s corporate culture? How did it contribute to the disaster?

A
  • Unethical culture
  • Poor tone at top
  • Executives ignored their fiduciary duty to the shareholders and other stakeholders
43
Q

What ethical paradigm did Ken Lay, Jeff Skilling, and Andy Fastow follow?

A

Ethical egoism

44
Q

Who created WorldCom and oversaw its growth through takeovers and false financial reporting?

A

Bernie Ebbers

45
Q

What went wrong at Sunbeam?

A
  • Turnaround artist Al “Chainsaw” Dunlap increased net income by fraudulently recording $62 million of sales
  • Company went into bankruptcy protection in 2001
46
Q

What went wrong at Adelphia Corporation?

A
  • Founded by John Rigas
  • Filed for bankruptcy in 2002
  • As a result of internal corruption by Rigas and his family
47
Q

What went wrong at Aurora Foods?

A
  • In 2001, company found guilty of underreporting expenses

- By $43.7 million to met analyst expectations

48
Q

What went wrong at Global Crossing?

A
  • Declared bankruptcy in 2002 (4th largest business failure in American history)
  • Market capitalization fell from billions to millions
49
Q

What went wrong at Waste Management?

A
  • March 2001, SEC filed charges against senior officers of company for fraudulently overstating pretax income by $3.5 billion from 1992 to 1996
  • AA paid a $7 million fine as a result of this audit failure
50
Q

What went wrong at Xerox?

A
  • April 2002, company fined $10 million (largest fine SEC ever levied) for fraudulently recognizing over $3 billion of equipment revenue from 1997 to 2000
51
Q

In response to the crisis of confidence as a result of all the scandals, what was passed to close the barn door?

A

SOX

52
Q

Was the enactment of SOX necessary?

A
  • YES (needed to address scandal, outrage, and outdated legislation)
  • NO (market should be allowed to self-correct; fraud was illegal even before SOX)
53
Q

What are the three most important improvements in the governance structure that could result from SOX?

A

1) Requiring directors on key committees (audit and nominating) to be independent and knowledgable
2) Establishing direct criminal liability on the part of the CEO and CFO for manipulations and/or failure to have appropriate control systems
3) Enhanced independence of external auditors

54
Q

SOX covers what three main areas?

A

1) Responsibilities of management
2) Conflicts of interest
3) Responsibilities of auditors and the audit committee

55
Q

SOX. What are the responsibilities of management?

A

1) Implement IC system to ensure company’s financial reports are
- accurate
- complete
- understandable
- transparent
2) Quarterly and annual financial reports must include certification
- by CEO and CFO
- attesting to scope, adequacy and effectiveness of company’s IC concerning financial reporting

56
Q

SOX. What does SOX require disclosure of in regards to conflicts of interest?

A

1) Disclosure of:
- management stock trades
- any dealings that management has w/ major investors
2) Publicly traded comanies to have a code of ethics

57
Q

SOX. What are the responsibilities of the auditors and the audit committee?

A
  • Directors who sit on audit committee be independent of management
  • Audit committee have at least one member who is financial expert, others must be financially literate
  • Audit committee have sufficient budget of time and money to complete work
  • Auditor report to audit committee w/o management being present.
  • Auditor may not provide any management services, other than tax and IT, to its audit clients
58
Q

After SOX, which of the following is not a prohibited non-audit service for external auditors?

a) appraisal or valuation services
b) bookkeeping and other services
c) legal services
d) tax services
e) internal audit outsourcing

A

d) tax services

59
Q

SOX established what entity?

A

PCAOB

60
Q

How many members is the PCAOB composed of?

A

5 (appointed by SEC)

61
Q

What is the PCAOB responsible for?

A
  • Charged with establishing auditing and attestation standards
  • Responsible for inspecting and disciplining accounting firms
62
Q

Are tax shelters in the public interest?

A

NO

63
Q

What are tax practitioners hired to do?

A

Provide advice to clients on how to pay maximize tax savings

64
Q

What did the tax practitioners at EY and KPMG do?

A
  • Too aggressive in designing tax strategies
  • Recommended that clients invest in tax shelters later judged to be illegal
  • Both firms fined
65
Q

In response to EY and KPMG’s tax shelters, what did the IRS implement?

A

Circular 230

66
Q

Expand on EY’s tax shelters.

A
  • 1990s, EY designed and marketed tax shelters that would delay paying taxes on stock options for up to thirty years
  • Aggressively marketed shelters to wealthy clients
  • IRS deemed shelters a sham and disallowed the tax deductions
  • Executives reassessed and had to pay millions in taxes and fines
  • EY reached a settlement with government and paid fine of $15 million
67
Q

Expand on KPMG’s tax shelters.

A
  • From 1996 to 2003, KPMG designed, implemented, and aggressively marketed tax shelters targeted at wealthy taxpayers
  • Abusive tax shelters generated at least $11 billion of artificial tax losses that cost US government $2.5 billion of evaded taxes
  • Government rejected shelters on basis that they had no economic purpose other than to reduce taxes
  • Taxpayers reassessed, tax deductions disallowed, and they had to pay taxes otherwise payable along with fines and penalties
68
Q

True or false.

KPMG’s tax shelters were considered so egregious that some wanted to see KPMG put out of business, but the government fined KPMG $456 million instead to prevent the Big 4 turning into the Big 3.

A

True

69
Q

In the wake of the EY and KPMG tax debacles, the IRS issued Circular 230 in Sept. 2007. Explain Circular 230.

A
  • Est. rules and suggested best practices for tax professionals
  • Basic rules are: 1) know client 2) serve client’s needs 3) explain and disclose fully 4) propose strategies likely to succeed
70
Q

True or false.

Circular 230 requires that any proposed tax strategy must have a better than 50 percent chance of success if there is a possibility that it will be challenged by the IRS.

A

True

71
Q

What went wrong at Tyco?

A
  • Widely known case of pervasive fraud perpetrated by top management
  • Top management treated Tyco as their private bank, taking out hundreds of millions of dollars of loans and compensation
72
Q

Who was the CEO of Tyco?

A

Dennis Kozlowski

73
Q

Who was the CFO of Tyco?

A

Mark Schwartz

74
Q

Who was the General Counsel of Tyco?

A

Mark Belnick

75
Q

What were weaknesses in Tyco’s governance processes?

A
  • In an environment of deceit
  • Too much trust by directors
  • Low ethical awareness
  • Opens door for unscrupulous executives to commit and conceal fraud
76
Q

What was ex-Tyco CEO Dennis Kozlowski convicted of?

A
  • Taking excessive bonuses totaling $430 million
  • Tax evasion
  • Stealing more than $100 million from Tyco
77
Q

Tyco. The patterns and improper conduct described took place for at least 5 years prior to 6/3/2002. What red flags or governance mechanisms should have alerted Tyco management accountants to the problem?

A
  • Lavish parties ($2 million for a birthday party)
  • Unreasonable loans to executives
  • Excessive executive compensation
78
Q

Tyco. What red flags or governance mechanisms should have alerted Tyco internal auditors to the problem?

A
  • Expense report for apartment (should’ve detected unusual expenses like $6,000 shower curtain)
79
Q

Tyco. What red flags or governance mechanisms should have alerted Tyco external auditors to the problem?

A
  • Should have detected very high executive expenditures

- OR uncollected loans through their audit procedures

80
Q

Tyco. What red flags or governance mechanisms should have alerted Tyco BOD to the problem?

A
  • Should have monitored more closely managements’ compensation
  • Should have avoided conflicts of interest
81
Q

Id and discuss the most important weaknesses in Tyco’s internal controls and governance systems.

A
  • Control environment did not have integrity, proper tone at top, and proper ethical values
  • Internal controls did not provide reasonable assurance that fraud will be prevented or detected
82
Q

Would a post-SOX whistleblowing program to the Audit Committee of the Board have eliminated the improper and illegal actions?

A
  • Unclear
  • Whistleblowing is the most common way by which fraud is uncovered (must be effective, independent, confidential, anonymous, non-retaliatory)
  • There is no substitute control for a solid ethical culture w/i an organization
83
Q

If you had been a professional accountant employed by Tyco during this time, and you wanted to blow the whistle, who would you have gone to with your story?

A
  • Unclear who to go to

- Maybe to SEC

84
Q

Why were so many Tyco employees willing to go along quietly with the looting by senior executives?

A
  • Bad example by senior management
  • Lack of effective whistleblowing program
  • Fear of retaliation from bosses
85
Q

Tyco. How many years did Kozlowski serve for his white-collar crimes?

A

8 years and now out on parole

86
Q

What does the Adelphia case offer a lesson about?

A

Importance of an independent and objective BOD that effectively challenges management w/ the necessary technical skills and knowledge to understand the business and its financial reporting

87
Q

What does the Adelphia case focus on?

A

Focuses on fiduciary duty of managers, directors, and auditors

88
Q

What was the key issue in the Adelphia case where the Rigas family treated the corporation as its own piggy bank?

A

What are the differences b/w family-owned and publicly-owned businesses

89
Q

Who founded Adelphia in 1952 in Coudersport, PA?

A

John Rigas

90
Q

True or false.

Rigas family members held 4 seats on a 7 member board.

A

True

91
Q

True or false.

The Rigas family used Adelphia as their own piggy bank for a golf club construction, property purchases, and stock deals.

A

True

92
Q

True or false.

Withdrawals coupled with bad management and rapid expansion led to a deteriorating financial position. This in turn led the Rigas family members to commit fraud.

A

True

93
Q

What breaches of fiduciary duty does the Adelphia case raise?

A
  • Board (both family and independent directors) had fiduciary duty to S/Hs
  • Auditors owed a duty to Adelphia’s S/Hs and general public
94
Q

Why do you think the Rigas family thought they could get away with using Adelphia as their own piggy bank?

A
  • Weak control environment

- Family members occupied key posts

95
Q

What allowed the Rigas family to get away with their fraudulent behavior for so long?

A
  • It was their business

- Small town, family owned

96
Q

What does the HealthSouth case point out?

A

How key weaknesses in the corporate governance structure may allow accounting fraud to pass without detection

97
Q

The HealthSouth case highlights how difficult it is to make CEOs and Directors accountable for fraud and for the ultimate loss of S/H value. How so?

A
  • In spite of the overwhelming evidence of his involvements in the fraud, CEO Richard Scrushy was acquitted
  • While the former CFO’s were subject to penalties b/w 15 and 30 years in jail and fines totaling $11.2 million
98
Q

What accounting fraud did HealthSouth perpetrate?

A
  • Used accruals and adjusting journal entries in accounting fraud
  • Accounting manipulations happened right after preliminary end-of-period results were reviewed in management meetings during the “off books” adjusting period
99
Q

HealthSouth. Was the CEO’s defense ethical?

A
  • NO

- Donated money to various charities to sway jury

100
Q

HealthSouth. Why did all the people who knew about the irregularities keep quiet?

A

Poor tone at the top

101
Q

HealthSouth. How, in accounting terms, did the manipulation of HealthSouth’s financial statements take place?

A
  • CEO says “fix it”
  • At family meetings, senior accounting personnel discussed what false accounting entries they could make w/o getting caught
102
Q

HealthSouth. What risk factors should EY have caught?

A
  • CFO turnover
  • Always meet earnings
  • CFO also Chairman
  • CEO past history
  • Fast growth

Ethics in Accounting (13 decks)

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