ISL452U-BUSINESS ETHICS
Chapter 7: Ethics in Accounting and Finance
Introduction
The emergence of financial reporting and audit scandals such as Enron, WorldCom, Global Crossing, Tyco International, Xerox, Parmalat, Royal Ahold have deeply shaken the trust in capital markets, corporate management, financial reports, independent audit companies and financial markets. Ethics in finance and accounting has regained the importance because of those scandals, crimes, and unethical practices by financial institutions.
The actual financial crisis emphasized the ethical and rational problems of actual financial theories; moreover, it will be necessary to integrate the ethical perspective into ethical models in order to give the financial field a public benefit.
When examined more closely, we can consider these financial scandals at three levels (McDonald, 2014, p. 180).
• Individual Level: individuals who were in key organizational positions and the ethicality of their decisions. • Corporate Level: the collective responsibility of all employees as well as the governance structures, systems and processes that operated within the organization to restrain appropriate behavior. • Regulatory Level: the interconnected organizations such as auditors, bankers, and other financial institutions cooperate in order to deceive or gain an advantage in the ongoing deception of the true company performance.
The idea that ethics, and in particular an ethical culture, has a place in finance and accounting, is widespread. It is seen to be an essential adjunct to the law as it applies in the form of financial regulation and has the support of national and international institutions.
Ethical Issues in Accounting and Finance
Business ethics apply to every area of business, whether it is breaking the agreement with your partners, showing misinterpreted ads on televisions, or child abuse, such companies get fined and punished for their unethical behavior. To avoid misunderstandings, it should be noted that it is not the intention of this contribution to distinguish between business ethics and ethics in finance.
Ethics in finance and accounting means the determination of general ethical principles for implementation and compliance in finance and accounting.
Ethical issues in accounting and finance might be related to the following broad themes:
• creative accounting, • misrepresentation and inaccurate financial reporting, • accounting fraud,
• investment scams, • conflict of interest, • insider trading, • hoarding, • black market, • bribery and extortion, • money laundering, • tax avoidance and tax evasion.
Sarbanes-Oxley Act (SOX for short) in the United States (2002) was a direct result of the ethical crises in financial management. SOX was enacted as a reaction to a number of major corporate and accounting scandals such as Enron, Tyco International, Adelphia, Peregrine Systems, and WorldCom. SOX has established provisions for the establishment of additional controls by the Securities and Exchange Commission to define how public corporations are to comply with the law. SOX also implemented stricter penalties for fraud and requires that chief financial officers sign off on their organization’s financial statements. This puts more responsibility towards the CFO and blames the CFO directly in cases of fraud. The purpose of this law is to re-establish public trust in the markets and to ensure the transparency, honesty and disclosure of financial information of public companies. By law, it is aimed to eliminate the distrust in financial markets while radically changing the way public companies do business and auditors supervise this business.
Business Ethics in Financial Markets
Finance is related to the generation, allocation and management of financial resources for any purpose. There are three main types of finance:
1. personal finance, 2. corporate finance, and 3. public finance.
Personal finance is the process of managing personal financial activities such as saving, investing, and borrowing money. The term often refers to the entire industry that provides financial services to individuals and households.
Corporate finance and accounting deal with financing, capital structure, business activity reporting, and analysis that management conducts to increase the value of the company.
Public finance is the management of a country’s revenue, expenditures, and debts to recognize when, how and why the government should intervene in the current economy, and also understand the possible outcomes of making changes in the market.
Most ethical norms in finance are embodied in laws and government regulations and are enforced by the courts and regulatory agencies.
Business Ethics in Corporate Finance and Accounting
Corporate finance and accounting deal with financing, capital structure, business activity reporting, and analysis. Finance managers, particularly the chief financial officers (CFOs) of firms, have the task of providing capital for a company and determining how that capital is to be deployed.
The corporate finance reflects the financial decisions taken by business managers to ensure financial management efficiency in the company. In corporate finance, financial decision affects the corporate value and is influenced by the corporate decisions of the manager. Finance managers decide to find, distribute and allocate financial resources.
In an agency relationship, one party (agent) is assigned to act on behalf of another (principal) and serve the interest of the other party. A fiduciary is a person who has been entrusted with the care of someone else’s property or other assets, and who has the responsibility to exercise discretionary judgment in the interests of the intended beneficiaries.
Accountants and financial managers are often confronted with ethical issues such as:
• Full disclosure and transparency • Professional duty vs. company demands • Individual judgment vs. demands from clients • Misrepresentation • Conflict of interest
These professions can also be understood as intermediaries acting between various parties in the market, and in this role, they are bound by ethical duties. Auditors verify a company’s financial statements so investors’ decisions are free of fraud and deception. Analysts evaluate a company’s financial prospects or creditworthiness so banks and investors can make informed decisions.
Relevance refers to how helpful the information is for financial decision-making processes.
Representational faithfulness is the extent to which information accurately reflects a company’s resources, obligatory claims, transactions, etc.
Dominant Ethical Principles in Accounting and Finance
The general ethical standards of society apply to everyone in every profession as well as to people in accounting and finance professions. Securing a financial system that represents the highest level of ethics is a common effort. People working in accounting and finance should have the necessary understanding of ethical behavior and the commitment to act accordingly, just being a good person will not be enough.
There are three valuable and overarching ethical principles that can be applied to most problems in financial services:
1. avoid deception and fraud, 2. honor your commitments, and 3. fulfill the true purpose of your professional role.
The Fundamental Principles of Ethics in Accounting and Finance
The ethical issues in accounting and finance cover a wide range of areas, such as financial management, activities in the financial services industry and financial markets. The same few basic ethical principles apply in all areas of accounting and finance, but certain ethical issues and problems require careful analysis.
For the purposes of our book and for the professionals and non-professional accounting and finance personnel, the following ethical principles appear to be most relevant.
• Integrity and Truthfulness • Independence and Objectivity • Confidentiality and Transparency • Professional Competence and Due Care • Professional Behavior • No Harm (No Maleficence) • Honesty • Fiduciary Duty • Trust
The Fundamental Principles of Ethics for Professional Accountants
The harmonization of national accounting systems to international standards are going to ensure full comparability of accounting information and also requiring common international ethical standards in accounting practices. In order to improve the image of the accounting profession and also prevent fraudulent accounting from taking place in institutions, accounting firms and governments have begun to promote ethics among accountants and introduced various regulations within the accounting profession. Due to the high expectations, the professions have adopted the ethical rules (codes of ethics), also known as professional codes of conduct.
These codes of conduct require for its members to maintain a level of self-discipline that goes beyond the requirements of laws and regulations.
The increasing focus on ethics has been expanded to include the accounting profession. We will consider some of the most common international codes of ethics for professionals such as IOSCO, IESBA, and INTOSAI as an example to stress the common ethical principles. We will consider the role of Codes of Conduct in encouraging ethical behavior.
The International Code of Ethics for Professional Accountants (“the Code”) provides a conceptual framework for professional accountants to apply in order to identify, evaluate and address threats to compliance with the fundamental principles. The fundamental
principles of ethics determine the standard of behavior expected from a professional accountant. A professional accountant shall comply with each of the fundamental principles.
Ethical Investment
Ethical investing (or socially responsible investing - SRI) is a strategy in which a person chooses investments according to a personal code of ethics. Ethical investment (or socially responsible investment) supports industries that are making a positive change, such as sustainable energy.
Ethical investment is generally defined as the integration of personal values, social considerations and economic factors into the investment decision. Financial return remains an important outcome, but it is not the only criterion driving investment; including ethical concerns and social benefit.
According to Domini’s classification, there are generally three different approaches to socially responsible investment (Domini and Kinder, 1986, p.2).
• The first one is the “avoidance approach”. In this approach, the investor does not invest in companies that engage in activities that do not comply with their social values. • The second approach is the “positive choice approach”. In this approach, investors actively invest in companies that operate in line with their social values. • The third approach is the “activist approach”. In this approach, the investor invests in companies that they want to change and use their ownership rights to make the changes.
Ethical savings, sharing capital, and microfinance and social lending can be considered as main financial tools in ethical savings and investments.
Financial Reporting and Corporate Governance
Financial and accounting misconducts were at the center of the biggest ethical and business failures of the past decade. These range from manipulating special purpose entities to defrauding lenders, cooking books, creating suspicious tax evasion, Ponzi schemes, insider trading, excessive pay for executives, fraudulently reporting loan rates.
What happened to the internal governance structures within these companies that should have prevented these disasters? Why did boards, auditors, accountants, lawyers and other professionals didn’t fulfill their professional, legal and ethical duties? Could better governance and oversight prevent these ethical scandals? Going forward, can we rely on internal governance controls to provide effective oversight, or do we need more effective external controls and government regulations? Many analysts claim that this corruption is evidence of a complete failure
in corporate governance structures (Hartman, DesJardins and MacDonald, 2014, p.526).
Effective governance involves many people and departments in an organization, such as internal audit, and accounting and finance functions. The board is responsible for setting the goals and strategy, spreading a coherent culture and providing oversight as the strategy is executed. However, the rest of the organization implements the strategy and each division plays an important role in governance.
One of the most effective guidelines is the OECD Corporate Governance Principles. OECD guidelines are often referenced by countries that develop local codes or guidelines. Based on the work of the OECD, other organizations have prepared their Guidelines on Good Practices in the Corporate Governance Disclosure. There are 5 broad categories:
• Auditing • Board and management structure and process • Corporate responsibility and compliance • Financial transparency and information disclosure • Ownership structure and exercise of control rights
These values should permeate all aspects of governance and should be demonstrated in all actions and decisions of the board.
Professional Ethical Oversight
To establish ethical codes and ethical offices in corporations and financial markets is a common work. The official regulatory agencies and self-regulating organizations established ethical codes to ensure ethically responsible behaviors in the financial sector.
International Institutions
The International Organization of Securities Commissions (IOSCO) is the international body that brings together the world’s securities regulators and is recognized as the global standard setter for the securities sector. IOSCO develops, implements and promotes adherence to internationally recognized standards for securities regulation. It works intensively with the G20 and the Financial Stability Board (FSB) on the global regulatory reform agenda.
Ethics in financial services generally takes the form of “codes”, that is, systematic statements of standards of conduct (e.g. those of the Chartered Financial Analyst (CFA) and Certified Financial Planner (CFP)).
National Institutions
One of the most important and powerful official regulatory agencies for the securities industry in Turkey is the Capital Markets Board of Turkey (CMB). Capital Markets Board of Turkey (CMB) is the regulatory and supervisory authority in charge of the securities markets in
Turkey. The CMB has been making detailed regulations for organizing the markets and developing capital market instruments and institutions.
Union of Chambers of Certified Public Accountants of Turkey (TÜRMOB) is authorized to (i) monitor compliance with initial and continuing professional development requirements for its members; (ii) translate and monitor ethical requirements; and (iii) investigate and discipline members for breach of rules and professional standards.
TÜRMOB has the special authority to issue a Code of Ethics for other professional accountants. TÜRMOB has also adopted the 2018 International Code of Ethics developed by the International Ethics Standards Board for Accountants (IESBA). TÜRMOB is a member of the IFAC.