Ethical Obligations And Decision Making in Accounting Text and Cases 4th Edition by Steven M Mintz Chair – Test Bank A+

Fair, Inc. agrees to release, indemnify, and hold Limits & Lobits, CPAs (its partners, heirs, executors, personal representatives, successors, and assigns) harmless from any liability and costs resulting from fraud caused by or participated in by management of Fair, Inc.

Do you think such a clause is ethical? Use ethical reasoning to support your answer with reference to professional standards.

Why might the facts of this case lead the attorney to conclude that a lawsuit against her client is imminent? How might the attorney assert a valid “good faith” defense?

a. What must a client prove to recover its losses from an auditor under common law?
b. What must a third party prove to recover losses from an auditor under common law?
c. How does an auditor’s ethical obligations and liability under common law intersect?

Describe the nature of these payments under the Foreign Corrupt Practices Act (FCPA) and assess their legality. What are the potential ethical issues of allowing certain types of payments under the Act?

Common law

Common-law liability evolves from legal opinions issued by judges in deciding a case. These opinions become legal principles that set a precedent and guide judges in deciding similar cases in the future. Statutory law reflects legislation passed at the state or federal level that establishes certain courses of conduct that must be adhered to by covered parties.

Common-law liability requires the auditor to perform professional services with due care. Evidence of having exercised due care exists if the auditor can demonstrate having performed services with the same degree of skill and judgment possessed by others in the profession. Typically, an auditor would cite adherence to generally accepted auditing standards as evidence of having exercised due care in conducting the audit. Due care includes exercising the degree of professional skepticism expected in the audit of financial statements.

An accountant has a contractual obligation to the client that creates a privity relationship. A client can bring a lawsuit against an accountant for failing to live up to the terms of the contract, asserting breach of contract, and other tort actions. When privity exists, plaintiffs must demonstrate all of the following:

1. They suffered an economic loss.
2. Auditors did not perform in accordance with the terms of the contract, thereby breaching that contract.
3. Auditors failed to exercise the appropriate level of professional care related to tort actions.
4. The breach of contract or failure to exercise the appropriate level of care caused the loss.

In addition to breach of contract, auditors may be liable to clients for tort liability that ranges from simple ordinary negligence to the more serious case of fraud. In the case of ordinary negligence, the auditor failed to exercise due care or the standard of care that other accountants would have done in similar situations.

Statutory Law

Auditors may have (statutory) legal liability under the Securities Act of 1933 and the Securities Exchange Act of 1934. These statutory liabilities may lead to convictions for crimes, provided their conduct was “willful.”

The Securities Act of 1933 regulates the disclosure of information in a registration statement for a new public offering of securities (i.e., IPO). Companies must file registration statements (S-1, S-2, and S-3 forms) and prospectuses that contain financial statements that have been audited by an independent CPA. Accountants who assist in the preparation of the registration statement are civilly liable if the registration statement (1) contains untrue statements of material facts, (2) omits material facts required by statute or regulation, or (3) omits information that if not given makes the facts stated misleading.

Section 11 of the Securities Act of 1933 imposes a liability on issuer companies and others, including auditors, for losses suffered by third parties when false or misleading information is included in a registration statement. Any purchaser of securities may sue: The purchaser generally must prove that (1) the specific security was offered through the registration statements, (2) damages were incurred, and (3) there was a material misstatement or omission in the financial statements included in the registration statement. The plaintiff need not prove reliance on the financial statements unless the purchase took place after one year of the offering.

If items (2) and (3) are proven, it is a prima facie case (sufficient to win against the CPA unless rebutted) and shifts the burden of proof to the accountant, who may escape liability by proving the following: (1) after reasonable investigation, the CPA concludes that there is a reasonable basis to believe that the financial statements were true and there was no material misstatement (the materiality defense); (2) a “reasonable investigation” was conducted (the due diligence defense); (3) the plaintiff knew that the financial statements were incorrect when the investment was made (the knowledge of falsehood defense); or (4) the loss was due to factors other than the material misstatement or omission (the lack of causation defense).

An accountant might argue that the false or misleading information is not material and thus should not have an impact on the purchaser’s decision-making process. The SEC and the courts have attempted to define materiality. The term material describes the kind of information that an average prudent investor would want to have so that he can make an intelligent, informed decision whether or not to buy the security. Thus, it is linked to objectivity. A material fact is one that, if correctly stated or disclosed, would have deterred or tended to deter the average prudent investor from purchasing the securities in question. The term does not cover minor inaccuracies or errors in matters of no interest to investors. Facts that tend to deter a person from purchasing a security are those that have an important bearing upon the nature or condition of the issuing corporation or its business.

To establish a due diligence defense, the defendant must prove that a reasonable investigation of the financial statements of the issuer and controlling persons was conducted. As a result, there was no reason to believe any of the information in the registration statement or prospectus was false or misleading. To determine whether a reasonable investigation has been made, the law provides that the standard of reasonableness is that required of a prudent person in the management of his own property. The burden of proof is on the defendant, and the test is as of the time the registration became effective. The due diligence defense, in effect, requires proof that a party was not guilty of fraud or negligence.

The due diligence defense available to the auditor under Section 11 requires that the auditor has made a reasonable investigation of the facts supporting or contradicting the information included in the registration statement. The test is whether a “prudent person” would have made a similar investigation under similar circumstances.

The Securities Exchange Act of 1934 regulates the ongoing reporting by companies whose securities are listed and traded on stock exchanges. The Act requires ongoing filing of quarterly (10-Q) and annual (10-K) reports and the periodic filing of an 8-K form whenever a significant event takes place affecting the entity, such as a change in auditors. Entities having total assets of $10 million or more and 500 or more stockholders are required to register under the Securities Exchange Act. The form and content of 10-K and 10-Q filings are governed by the SEC through Regulation S-X (which covers annual and interim financial statements) and Regulation S-K (which covers other supplementary disclosures).

Section 18 of the Act imposes liability on any person who makes a material false or misleading statement in documents filed with the SEC. The auditor’s liability can be limited if the auditor can show that she “acted in good faith and had no knowledge that such statement was false or misleading.” However, a number of cases have limited the auditor’s good-faith defense when the auditor’s action has been judged to be grossly negligent.

The liability of auditors under the act often centers on Section 10 and Rule 10b-5. These provisions make it unlawful for a CPA to (1) employ any device, scheme, or artifice to defraud; (2) make an untrue statement of material fact or omit a material fact necessary in order to make the statement made, in the light of the circumstances under which they were made, not misleading; or (3) engage in any act, practice, or course of business to commit fraud or deceit in connection with the purchase or sale of the security.

Once a plaintiff has established the ability to sue under Rule 10b-5, the following elements must be proved: (1) a material, factual misrepresentation or omission, (2) reliance by the plaintiff on the financial statements, (3) damages suffered as a result of reliance on the financial statements, and (4) the intent to deceive, manipulate, or defraud (scienter).

Common law cases

In the 1933 landmark case, Ultramares v. Touche, the New York State Court of Appeals held that a cause of action based on negligence could not be maintained by a third party who was not in contractual privity. The court did leave open the possibility that a third party could successfully sue for gross negligence that constitutes fraud and actual fraud.

The importance of the Ultramares decision is that third parties (i.e., Ultramares) without privity could sue if negligence was so great as to constitute gross negligence. The opinion of the New York Court of Appeals was written by Judge Benjamin Cardozo.

If a liability for negligence exists, a thoughtless slip or blunder, the failure to detect a theft or forgery beneath the cover of deceptive entries, may expose accountants to a liability in an indeterminate amount for an indeterminate time to an indeterminate class [third parties]. The hazards of a business on these terms are so extreme as to [raise] doubt whether a flaw may not exist in the implication of a duty that exposes to these circumstances.

The Ultramares decision was the first of three different judicial approaches to deciding the extent of an accountant’s liability to third parties. The other two are the Restatement (Second) of the Law of Torts approach and the foreseeable third-party approach.

With respect to liability to third parties, while the Ultramares decision established a strict privity standard, a number of subsequent court decisions in other states moved away from this standard over time. The New York Court of Appeals expanded the privity standard in the case of Credit Alliance v. Arthur Andersen & Co. to include a near-privity relationship between third parties and the accountant. In the case, Credit Alliance was the principal lender to the client and demonstrated that Andersen had known Credit Alliance was relying on the client’s financial statements prior to extending credit. The court also ruled that there had been direct communication between the lender and the auditor regarding the client.

The Credit Alliance case establishes the following tests that must be satisfied for holding auditors liable for negligence to third parties: (1) knowledge by the accountant that the financial statements are to be used for a particular purpose; (2) the intention of the third party to rely on those statements; and (3) some action by the accountant linking him or her to the third party that provides evidence of the accountant’s understanding of intended reliance.

The “middle ground” approach followed by the vast majority of states (and federal courts located within those states) expands the class of third parties that can sue successfully an auditor for negligence beyond near-privity to a person or limited group of persons whose reliance is (actually) foreseen, even if the specific person or group is unknown to the auditor.

The courts have deviated from the Ultramares principle through a variety of decisions. For example, a federal district court in Rhode Island decided a case in 1968, Rusch Factors, Inc. v. Levin, that held an accountant liable for negligence to a third party that was not in privity of contract. In that case, Rusch Factors had requested financial statements prior to granting a loan. Levin audited the statements, which showed the company to be solvent when it was actually insolvent. After the company went into receivership, Rusch Factors sued, and the court ruled that the Ultramares doctrine was inappropriate. In its decision, the court relied heavily on the Restatement (Second) of the Law of Torts.

The Restatement (Second) of the Law of Torts approach, sometimes known as Restatement 552, expands accountants’ legal liability exposure for negligence beyond those with near privity (actually foreseen) to a small group of persons and classes who are or should be foreseen by the auditor as relying on the financial information. This is known as the foreseen third-party concept because even though there is no privity relationship, the accountant knew that that party or those parties would rely on the financial statements for a specified transaction.

A majority of states now use the modified privity requirement imposed by Section 552 of the Restatement (Second) of the Law of Torts. The Restatement modifies the traditional rule of privity by allowing non-clients to sue accountants for negligent misrepresentation, provided that they belong to a “limited group” and provided that the accountant had actual knowledge that his or her professional opinion would be supplied to that group. In some state court decisions, a less restrictive interpretation of Section 552 has been made. For example, a 1986 decision by the Texas Court of Appeals in Blue Bell, Inc. v. Peat, Marwick, Mitchell & Co. (now KPMG) held that if an accountant preparing audited statements knows or should know that such statements will be relied upon, the accountant may be held liable for negligent misrepresentation.

A third judicial approach to third-party liability expands the legal liability of accountants well beyond Ultramares. The reasonably foreseeable third-party approach results from a 1983 decision by the New Jersey Supreme Court in Rosenblum, Inc. v. Adler. In that case, the Rosenblum family agreed to sell its retail catalog showroom business to Giant Stores, a corporation operating discount department stores, in exchange for Giant common stock. The Rosenblum’s relied on Giant’s 1971 and 1972 financial statements, which had been audited by Touche (now Deloitte & Touche). When the statements were found to be fraudulent and the stock was deemed worthless, the investors sued Touche. The lower courts did not allow the Rosenblum’s claims against Touche on the grounds that the plaintiffs did not meet either the Ultramares privity test or the Restatement standard. The case was taken to the New Jersey Supreme Court, and it overturned the lower courts’ decision, ruling that auditors can be held liable for ordinary negligence to all reasonably foreseeable third parties who are recipients of the financial statements for routine business purposes.

The legal liability of accountants is not limited to audited statements. In the 1967 case 1136 Tenants Corp. v. Max Rothenberg & Co. an accounting firm was sued for negligent failure to discover embezzlement by the managing agent who had hired the firm to “write up” the books, which did not include any audit procedures. The firm was held liable for failure to inquire or communicate about missing invoices, despite a disclaimer on the financial statements informing users that “No independent verification were undertaken thereon.” The firm moved to dismiss the case, but the court denied the motion and held that even if a CPA “acted as a robot, merely doing copy work,” there was an issue as to whether there were suspicious circumstances relating to missing invoices that imposed a duty on the firm to warn the client.

(REMIND STUDENTS TO LOOK AT EXHIBIT 6.2)

Two court decisions illustrate the application of Section 11 of the Securities Exchange Act of 1933 to securities registration matters: Escott v. BarChris Construction Corp. and Bernstein v. Crazy Eddie, Inc. (These cases are summarized in Exhibits 6.4 and 6.5, respectively.)

In Escott v. BarChris Construction Corp., the company issued a registration statement in 1961 in connection with its public offering of convertible bonds. The statements included audited financial statements by Peat, Marwick, Mitchell & Co. The financial statements included material overstatements of revenues, current assets, gross profit, and backlog of sales orders and material understatements of contingent liabilities, loans to company officers, and potential liability for customer delinquencies. BarChris’s worsening financial position resulted in a default on interest payments and the company eventually declared bankruptcy. Barry Escott and other investors sued BarChris’s executive officers, directors, and the auditors under Section 11 of the Securities Act, citing a lack of appropriate professional care during the conduct of the audit. The judge ruled that the auditor’s actions in reviewing events subsequent to the balance sheet date were not conducted with due diligence because the senior auditor in charge of reviewing these events had not spent sufficient time and accepted unconvincing answers to key questions. The court determined that there had been sufficient warning signs that further investigation was necessary. The auditors’ failure to perform a reasonable investigation of subsequent events did not satisfy Section 11(b) and resulted in their liability to investors in BarChris’s bonds.

Crazy Eddie made several public offerings of securities from 1984 through 1987, during which time the prospectuses wrongly gave the impression that the company was a growing concern. The financial statements had been misstated by a number of schemes, including inflated inventory and net income. The plaintiffs in the case were purchasers of the company’s stock prior to the disclosure of the fraudulent financial statements. They sued Peat Marwick, the board of directors, and others, alleging that the accounting firm had violated GAAS and GAAP by failing to uncover the company’s fraudulent and fictitious activities. The plaintiffs were able to show that they suffered a loss and that the certified financial statements in the registration statements and prospectuses had been false and misleading, in violation of Sections 11 and 12 of the Securities Acts of 1933. The court decided the plaintiffs did not have to prove fraud or gross negligence, only that any material misstatements in the registration statements were misleading and that they had suffered a loss. In this case, the auditor was unable to prove that they had exercised appropriate due professional care to rebut the claim.

An important case that strengthens the scienter requirement is the 1976 U.S. Supreme Court reversal in Ernst & Ernst v. Hochfelder. The U.S. Court of Appeals had ruled in favor of Hochfelder and reversed the lower court opinion. The court decision includes this statement: “One who breaches a duty of inquiry and disclosure owed another is liable in damages for aiding and abetting a third party’s violation of Rule 10b-5of the Securities Exchange Act of 1934 if the fraud would have been discovered or prevented but for the breach, and that there were genuine issues of fact as to whether [Ernst] committed such a breach, and whether inquiry and disclosure would have led to discovery or prevention of the… fraud.”

The U.S. Supreme Court reversed the lower court’s decision that a private cause of action can come under Rule 10b-5. The Supreme Court ruled that a private cause of action for damages does not come under Rule 10b-5 in the absence of any allegation of scienter. The Court cited the language in Section 10 that it is unlawful for any person to use or employ any manipulative or deceptive device or contrivance in contravention of SEC rules. The Court ruled that the use of those words clearly shows that it was intended to prohibit a type of conduct quite different from negligence. The term manipulative connotes intentional or willful conduct designed to deceive or defraud investors, a type of conduct that did not exist in the case.

In a footnote to the decision, the Court recognized that in certain areas of the law, recklessness is considered to be a form of intentional conduct for the purpose of imposing liability for some act, thereby providing potential exposure to auditors for gross negligence under the Securities Exchange Act.

The role of the external auditor is to perform an audit in accordance with generally accepted auditing standards (GAAS) upon which the auditor renders an independent opinion whether those statements have been prepared in accordance with generally accepted accounting principles (GAAP) that have been consistently applied and contains full and fair disclosures of information the public needs to know. The auditor’s examination of client-prepared financial statements is designed to evaluate whether any material misstatements in the financial statements exist as a result of fraud or illegal acts.

The audit must be carried out with objectivity, due care, and professional skepticism. Auditors are not guarantors that fraud will be detected. Instead, the opinion provides reasonable assurance that the financial statements are free of material misstatements due to fraud. As long as the auditor meets these standards, a due diligence defense can be asserted.

Here are four key questions to answer that may help successfully defend a lawsuit alleging auditor malpractice.

Was the audit done in accordance with professional standards?

GAAS apply to the audits of all entities while the auditing standards of the Public Company Accounting Oversight Board (PCAOB) applies to registrants with the SEC. A key standard is Consideration of Fraud in a Financial Statement Audit (AU-C section 240). This standard outlines the process auditors must go through as they consider the possibility that fraud could occur within the company. Was the issue of fraud appropriately considered, and were audit procedures designed accordingly? Did the audit team thoughtfully consider the issue of fraud and thoroughly examine any possible issues before deciding on a scope of work as it relates to fraud.

Auditors should follow the guidelines of the fraud triangle to assess the risk of fraud: pressures/incentives to commit fraud; opportunity to do so; and the rationalizations that are typically given to rationalize the fraud. It is critically important to carefully assess management’s representations with respect to assertions in the financial statements and to gather sufficient, competent evidential matter to support those assertions. During the course of the audit, auditors must document due care and professional skepticism as these are areas often probed during litigation.

Do the working papers show that the auditors completed all the procedures suggested by the audit program?

Auditors do have some latitude in designing audit procedures, based on their evaluation of materiality and of the risks facing the company and the results of testing. This is an area in which the auditors are likely to get tripped up in a lawsuit, however, if their documentation procedures are not thorough.

It is important for auditors to determine whether any problems discovered during audit testing were dealt with appropriately. For example, if the auditors’ testing revealed that documentation did not support numbers in a certain area of the financial statements (or documentation was not available), then the auditors must follow this with additional analysis and/or procedures.

Did staff, managers, and partners sign off on the work programs appropriately?

In addition to performing all the appropriate audit procedures, the auditors must document this work (and relevant issues to consider) in the work programs. Do the work programs reflect the work actually done? Was a box checked or a space signed only if the work was actually done? This can be a tedious thing to analyze, as the expert must go through all of the work programs in conjunction with the workpapers, and make sure that the representations in the work programs match the documented work.

Were firm quality controls adequately applied including second partner/technical review partner reviewing the working papers?

The engagement partner has ultimate responsibility for the audit. Audit firms demonstrate due care when they have a second partner review those work papers including any that indicate differences of opinion with management and how they were resolves as well as communications with the audit committee. An important consideration is whether the firm reviewed management’s report on internal controls over financial reporting and whether the firm issued its own report based on that assessment. This is required under section 404 of SOX. PCAOB inspections oftentimes identify internal control assessments as deficiencies based on inspections of audit working papers.

Fair, Inc. agrees to release, indemnify, and hold Limits & Lobits, CPAs (its partners, heirs, executors, personal representatives, successors, and assigns) harmless from any liability and costs resulting from fraud caused by or participated in by management of Fair, Inc.

Do you think such a clause is ethical? Use ethical reasoning to support your answer with reference to professional standards.

With the continuing focus on management fraud and an auditors’ responsibility to detect fraud, some CPAs have expressed an interest in including an indemnification clause covering management fraud in engagement letters. Where management fraud is not detected by the auditor and litigation ensues, the success of this clause in protecting the CPA would be dependent upon the views of the governing jurisdiction.

An indemnification or hold harmless clause in an engagement letter typically provides that the client will indemnify or hold the CPA harmless in the event the CPA sustains a loss resulting from claims arising from the CPA’s work on the subject engagement. Indemnification clauses are not intended to preclude the CPA from incurring liability for professional malpractice. Instead, such a clause is intended to preclude liability where the client knowingly makes misrepresentations to the CPA, causes or participates in a fraud, conceals information from the CPA, or otherwise leads the CPA astray.

Where permitted, indemnification clauses may provide valuable benefits to the CPA. For example, the inclusion of an indemnification clause could prove to be a deterrent to a client considering a potential claim against a CPA firm. Recognizing the existence of the indemnification clause, the client may view an action against the CPA as being without potential benefit. Further, for the CPA and client desiring to keep the engagement risk and reward equation in balance, the use of an indemnification clause could provide support for the CPA’s adjusting the fee for the subject services. Also, the upfront discussion and use of such a clause affords the parties the opportunity to address their specific risk management and risk allocation needs before the engagement commences and thereby provide both parties with knowledge of their individual limits and exposures.

The ethical issue turns on whether these clauses could jeopardize an auditor’s performance and independence. Given that independence is both a factual determination as well as the appearance of independence, it would seem that a reasonable observer might conclude that an auditor(s) is less diligent in doing all that is necessary to find fraud if, for example, the audit is late and above budget because of the limitation of liability. On the other hand, the auditor(s) liability to investors and other third party users cannot be similarly limited.

For some time the position of the SEC and PCAOB with regard to the use of an indemnification provision by a CPA/CPA firm auditing a public company has been that an agreement that provides complete indemnification to an auditor impairs independence in attest engagements. Prior to the revision to the AICPA Code, such indemnification clauses were permitted so that they were acceptable by the profession for non-public companies.

The Revised AICPA Code contains a provision under section 1.228.020, Indemnification of Attest Client, that indemnification clauses in audit engagement letters create a threat to independence that cannot be reduced to an acceptable level by the application of safeguards if the covered member (CPA on the attest engagement team) enters into an agreement providing, among other things, that the covered member indemnifies the attest client for damages, losses, or costs arising from lawsuits, claims, or settlements that related, directly or indirectly to the attest client’s acts. The covered member’s independence would be impaired under these circumstances.

The ethics of using an indemnification clause in an audit engagement is best viewed through the prism of fairness. Is it fair for a CPA firm to be held legally liable when client management knowingly deceives the auditor about a financial matter and then takes steps to cover its tracks? On the other hand, is it fair to the client to have such limitations on CPAs’ liabilities if, for example, a rogue employee caused the fraud and, as alleged by the client, the CPAs should have discovered it through their audit procedures?

There is no simple answer to the fairness issue because it depends on the underlying circumstances. CPAs who seek to limit their liability to clients when management fraud leads to materially misstated financial statements seek to hold management legally liable for its own fraud. Responsibility and accountability are integral elements in ethical behavior.

From a utilitarian perspective, the CPA could easily justify using indemnification clauses because the costs to them are negligible while the benefits of not being financially responsible for management fraud are substantial. From a practical perspective, it may not be so easy to determine where management fraud begins and audit insufficiencies start.

Another aspect of this issue is that audit engagement agreements between a company and its auditor aren’t public documents. As a result, some investors are pushing companies to spell out these provisions and make their implications crystal clear.

Why might the facts of this case lead the attorney to conclude that a lawsuit against her client is imminent? How might the attorney assert a valid “good faith” defense?

The attorney probably believes the allegations may create a strong inference that the CFO acted with the required state of mind, or scienter, which is a mental state that reflects a defendant’s intent to deceive, manipulate, or defraud. Scienter is a required element of a private securities fraud claim.

The Private Securities Litigation Reform Act strengthened the pleading standards for fraud cases by requiring the plaintiff to state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind. The courts look at whether the defendant’s motive and opportunity to commit fraud reflect evidence of conscious misbehavior or recklessness.

A legal principle that makes officers, directors, managers, and other agents of a corporation immune from liability is when their decisions are made in good faith. Under the business judgment rule, the officers and directors of a corporation are immune from liability to the corporation for losses incurred in corporate transactions within their authority, so long as the transactions are made in good faith and with reasonable skill and prudence.

a. What must a client prove to recover its losses from an auditor under common law?
b. What must a third party prove to recover losses from an auditor under common law?
c. How does an auditor’s ethical obligations and liability under common law intersect?

a. A client has a privity relationship with the auditor, which makes the auditor liable for fraud, gross negligence, and ordinary negligence. To recover losses under common law, a client must prove losses, reliance on the auditors’ representations, that the reliance was proximate cause of the losses, and negligence on the part of the auditors.

b. A third party is not in a contractual relationship with the auditor. The auditor has a liability for fraud and gross negligence but it is not completely clear that the auditor would be liable to the client for ordinary negligence. Common law decisions establish legal standards for liability in that regard.

Generally, to recover losses under common law, ordinary third parties must prove losses, reliance on the auditors’ report, that the reliance was proximate cause of the losses, and gross negligence on the part of the auditors. Courts may also require demonstrating a direct link between the auditor and third party and that the third party was not negligent in using the audited information for decision making.

c. The student may use rights, deontology, utilitarianism, or virtue theories to argue that if the auditor does his job, meeting all duties and obligations, then the law and ethical obligations are in alignment. For example, the diligent auditor demonstrates objectivity, due care and professional skepticism, and virtues that are critical to conducting an audit in accordance with GAAS. An auditor that places his obligation to third parties, such as creditors, ahead of that to the client, is meeting his public interest responsibility. Investors and creditors have a right to receive accurate and reliable financial report information. Auditors should act in a way they would want other auditors to act in similar situations for similar reasons so that their actions have universal appeal and would be acceptable to a broad group of accounting professionals. Utilitarianism comes into play when applying rule utilitarianism which holds that regardless of utilitarian benefits (act utilitarianism), certain rules should never be violated including knowingly providing false information to a third party.

Describe the nature of these payments under the Foreign Corrupt Practices Act (FCPA) and assess their legality. What are the potential ethical issues of allowing certain types of payments under the Act?

The payments of $100-$500 to expedite off-loading of the goods are facilitating payments because they are made to expedite a process, but one that should occur as a normal course of business except for the payment. It is common in many countries to have to “grease the wheels” to get things done that should be done anyway because it is part of the acting officials routine duties.

The sponsoring of guests from state-owned enterprises to attend the Olympics in China are bribe payments to win lucrative contracts to be awarded to Chinese businesses as a return favor. It is a “quid pro quo,” or something that is given to someone or done for someone in return for something given to or done for someone else. The covering of expenses for the guests is a payment to be awarded the future contracts so they are made to induce a behavior that otherwise should not necessarily be done until and unless a competitive bidding process is allowed to play out.

Facilitating payments involve a set of questionable behaviors because:

• The custom official has an incentive not to carry out her duties of resolving the issues entrusted to her as swiftly or as efficiently as is to be expected of a conscientious public servant.
• The Chinese companies are entitled to the service, and have it delivered on a timely basis.
• The official may ask for larger and larger payments over time especially if foreign suppliers agree to make these payments readily.
• Facilitating payments may represent a step towards a culture of corruption in society above all if instances of easy wealth, legal impunity and willingness to break the law proliferate.
• The Chinese companies may take the initiative to offer other officials facilitating payments believing it is part of the cost of doing business in these countries even if such payments are not requested.
• Facilitating payments lead to inefficiencies in the providing of services to Chinese and other companies that play the game.
• Shareholders are not aware of the payments generally speaking and probably would not approve of the use of the company’s resources in that way.
• If the use of facilitating payments becomes common practice, they have a corrosive effect on people’s trust in legal, administrative and judicial procedures.

Ethical legalism is at play in this case. Facilitating payments are legal but not very ethical. Just imagine if every company had to make such payments to get things done (They do in some countries). The level playing field for multinationals is lost unless every company makes the payments and then the requested payments would likely increase in amount. It becomes a snowball effect and once a company agrees to such payments, it has begun the slide down the ethical slippery slope.

Facilitating payments have a pernicious effect on the working of the requesting government administration because all too often they are the slippery slope to more serious forms of corruption. They impose additional costs on companies and citizens and in the long run threaten the ethical foundations of organizations.

In FCPA enforcement, cultural norms are irrelevant. It does not matter to law enforcement whether corrupt acts – like paying “commissions” to sales agents in Brazil making small payments to regulatory officials in Turkey – are standard practice in a certain country.

It is true that the FCPA provides an affirmative defense for activity that is lawful under written local laws or regulations. But we know of no written local laws that legalize bribery, even petty corruption. However, arguments are sometimes made in favor of making exceptions to anti-bribery rules based on local culture. Consider the following rationalizations for facilitating payments and/or bribes.

1. “In cultures where bribery is accepted, it is justified.” This argument implies that some cultures are inherently more corrupt than others. Not surprisingly, this view is frequently offensive to people from the “more corrupt” cultures, and the argument is further weakened by the difficulty of measuring and defining corruption.

The view also suggests that tolerating bribery equates to implicit approval or acceptance by a country’s people. If you were to ask people on the streets of Rio de Janeiro, Brazil or Lagos, Nigeria if they approve of officials who accept bribes, you would get few, if any, “yeses”. People in countries with high corruption understand the personal impact of procurement officials who select low quality goods like poorly constructed roads and bridges in exchange for kickbacks.

2. “In some countries, bribery is built into the economy.” In other words, the system itself expects bribery. The tax collector must demand bribes because she is not paid enough to live on. But, even considering these human dimensions, corruption is still criminal. The plight of low-level officials highlight not the need for more bribes but the need for improved state systems. If a company wants to change such systems to improve the business environment, there are ways to do this short of bribery.

3. “Bribes make an economy more efficient.” Some argue that bribes make economies work better by, for example, streamlining bureaucracies. But, in practice, the opposite is generally true. When corruption is tolerated, bureaucrats have an incentive to create more choke points from which they can extract even more benefits.

4. “These are not bribes, they are something else.” One of the trickiest areas for FCPA compliance is determining when a gift, entertainment, or something else of value that is acceptable in one culture is actually a bribe under the FCPA. What if business people would regularly take high-ranking public officials to expensive dinners and say that is the way things are done. But is it legal?

Complicated matters like these must be decided on a case-to-case basis with the participation and judgment of a compliance officer, attorney, and other qualified management. They should be decided with careful consideration of the company’s own compliance program, acceptable standards in the industry, and law enforcement’s guidance in previous actions, opinion releases, public statements, and other sources of authority.

Geert Hofstede’s studies of cultural values were discussed in Chapter 1. Originally, Hofstede was able to draw out four dimensions of culture, which included: power distance, uncertainty avoidance, individualism, and masculinity. He later added a fifth – long-term orientation.

Power distance was thought to capture the extent to which there was equality in power between members in society. For example, in a society where there is great power distance, many individuals accept the authority and have no say in decisions that are made. With respect to facilitating payments, a society with a high score on power distance might tolerate such payments because of the strong authority position of the central government. A low score on individualism implies a society run for the collective good with loyalty to the group, citizenry and government. Here, facilitating payments are more likely to be accepted by society in order to “go along to get along.” The same result would occur with a high score on uncertainty avoidance as people in that kind of society do not want to rock the boat. If a person has weak uncertainty avoidance then they will be content with letting things happen as they may.

A company’s CEO and CFO must each provide two certifications as part of the company’s quarterly Form 10-Q and annual Form 10-K. The certifications are required under Sections 302 and 906 of the SOX. The certifications are executed individually and filed as exhibits to the applicable quarterly and annual filings. Although certifications are not included in reports other than Forms 10-Q and 10-K, the disclosure controls and procedures to which the CEO and CFO certify must ensure full and timely disclosure in all current reports, as well as definitive proxy materials and definitive information statements.

Under Section 302, the CEO and CFO make statements related to the accuracy of the reports filed with the SEC and the controls and procedures established by the company to ensure the accuracy of such reports. The certification must be in the exact form set forth in the rule, and the wording may not be changed in any respect whatsoever. The CEO and CFO must each certify that:

• She has reviewed the report;
• Based on her knowledge, the report does not contain any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances, not misleading;
• Based on her knowledge, the financial statements and financial information fairly present, in all material respects, the company’s financial condition, results of operations and cash flows of the company;
• The certifying officer(s) is/are responsible for:

• establishing and maintaining disclosure controls and procedures;
• having designed such disclosure controls and procedures to ensure that they are informed of all material information;
• having each evaluated the effectiveness of the disclosure and financial controls and procedures as of the end of each period in which they are making the certification; and
• having disclosed their conclusions regarding the effectiveness of the controls and procedures in the subject Form 10-Q or 10-K;

• She has disclosed to the company auditors and to the audit committee any significant deficiencies or material weaknesses in the design or operation of internal controls over financial reporting which could adversely affect the company’s ability to record, process, summarize and report financial data;
• She has disclosed to the company auditors and to the audit committee any fraud, material or not, that involves employees who have a significant role in internal controls over financial reporting; and
• She has disclosed any changes in the internal controls or financial reporting in the subject Form 10-Q or 10-K, including changes designed to correct deficiencies or material weaknesses.

If a material weakness is uncovered, it must be disclosed in a Form 10-K and, as a result, management cannot conclude that its controls and procedures are effective. The SEC defines a material weakness to be a deficiency, or a combination of deficiencies, in internal control over financial reporting that creates a reasonable possibility that a material misstatement of a company’s annual or interim financial statements will not be prevented or detected on a timely basis. The disclosure of a material weakness should include the nature of the weakness, its impact on financial reports and plans or steps and changes made to correct the disclosed material weakness.

Section 302 does not specify methods or procedures that should be used for effective internal controls and procedures. Rather, the SEC encourages CEO’s and CFO’s to develop systems that best fit the facts and circumstances of their particular enterprises. However, the SEC has given some guidance, encouraging that management (i) develop and continually test its procedures and their effectiveness; (ii) that evaluation be documented in writing, including methods used to test and evaluate procedures and the conclusions and results; (iii) keep good records and documentation; and (iv) rely on outside auditors and advisors to provide input.

In order to ensure that the CEO and CFO certifications are accurate and can properly be executed, a company must establish the underlying procedures to which the CEO and CFO evaluate and attest. The controls and procedures must be designed to address both quality and timeliness of disclosure. Unlike pre-existing concepts of internal controls over financial reporting, the SOX certifications include required material non-financial information, as well as financial information.

The SEC has identified the Treadway Commission Committee of Sponsoring Organizations report and framework on internal controls as an acceptable system and accordingly, it is almost uniformly used and relied upon. The Treadway Commission has published a separate report directed towards internal control systems for smaller public companies. The report noted that smaller companies’ management tends to have a hands-on approach, wider spans of control and the ability to provide ongoing monitoring through direct relationships with key personnel, customers, vendors and capital providers that, along with in-depth knowledge of operations, processes, contractual commitments and business risks, can create opportunities for controls to be effective while being less formal. Managers in smaller public companies are more directly involved with the company’s controls on a daily basis.

In general, as signors of such reports, the CEO/CFO can be liable for material misstatements or omissions under general antifraud standards and under the SEC authority to pursue actions against those who cause or aid or abet securities law violations. An officer providing a false certification potentially could be subject to SEC action for violating Section 13(a) or 15(d) of the Exchange Act and to both the SEC and private actions for violating Section 10(b) of the Exchange Act and Exchange Act Rule 10b-5.

Two examples of insider trading were discussed in Chapter 4 – Scott London at KPMG and Thomas Flanagan at Deloitte. Scott London, an audit partner at KPMG who traded on inside information and violated audit independence by leaking confidential information to his friend, Brian Shaw, about Deckers, Pacific Capital Bancorp, Skechers, and Herbalife – all audit clients of KPMG. The leak of information about quarterly earnings information led to Shaw’s unjust enrichment of $1.27 million. Shaw, a jewelry store owner and country club friend of London, repaid London with $50,000 in cash and a Rolex watch, according to legal filings.

London settled administrative proceedings with the Securities and Exchange Commission that includes SEC sanctions and forfeiture of the right to appear or practice before the SEC as an accountant. On the criminal side, London was convicted of insider trading in June 2014, and is serving a 14-month sentence for his crime.

In 2010, Deloitte and Touche was investigated by the SEC for repeated insider trading by Thomas P. Flanagan, a former management advisory partner and a Vice Chairman at Deloitte. Flanagan traded in the securities of multiple Deloitte clients on the basis of inside information that he learned through his duties at the firm. The inside information concerned market moving events such as earnings results, revisions to earnings guidance, sales figures and cost cutting, and an acquisition. Flanagan’s illegal trading resulted in profits of more than $430,000. In the SEC action, Flanagan was sentenced to 21 months in prison after he pleaded guilty to securities fraud. Flanagan also tipped his son, Patrick, to certain of this material non-public information. Patrick then traded based on that information. His illegal trading resulted in profits of more than $57,000.

A number of additional situations can cause an actual breach of independence, or—just as serious—the appearance of such a breach. These include the following:

1. Employment relationships. AICPA and SEC independence rules both provide that an audit firm’s independence will be impaired if former firm professionals are subsequently employed by or associated with an attest client in a key position, unless certain conditions are met. In addition, the SEC rules, being the more restrictive, include shareholders as covered members and require a one year cooling-off period before a company can hire an individual formerly employed by its auditor for a position involving oversight of the financial reporting process at the registrant entity.

2. Direct or material indirect financial interests. The AICPA and SEC independence rules both explicitly state that a member or a member’s firm may not have or be committed to acquire any direct or material indirect financial interests in a client. Further, both the AICPA and SEC independence rules provide similar, but not identical, language regarding guidance on situations in which serving as a trustee or executor of an estate that has a direct or material indirect financial interest in the client will impair independence.

3. Loans to and from clients. AICPA guidance provides that all loans to or from clients, without regard to materiality, impair independence (unless the loan is from a financial institution and certain criteria are met).

4. Business relationships. AICPA and SEC independence rules provide that business relationships with clients – such as joint ventures, limited partnership agreements, investments in supplier or customer companies and sales by the member of items other than professional services – will impair independence. AICPA rules regarding business relationships with clients provide that if a member or a member’s firm has a material joint, closely held business investment with a client, independence is impaired. A joint closely held business investment refers to an investment that is subject to the control of the member or the member’s firm, the client, the client’s officers, directors or principal stockholders or any combination thereof. The AICPA rules address such situations as creating a threat to independence that must be mitigated by specific safeguards to avoid violating the independence rules.

The foregoing are certainly not the only instances in which auditor independence could be lost or threatened. Importantly, since the appearance of independence must be maintained, various permutations of these fact patterns, even if not expressly addressed by SEC or AICPA rules, could give rise to allegations of breaches making auditors vulnerable to assertions of malpractice.

As further scrutiny is placed on auditor independence, in both fact and appearance, it is probable that auditor liability due to violations of auditor independence will remain an area ripe for litigation.