Research on Professional Responsibility and Ethics in Accounting, Volume 12 (Research on Professional Responsibility and Ethics in Accounting) (Research ... Responsibility and Ethics in Accounting)

RESEARCH ON PROFESSIONAL RESPONSIBILITY AND ETHICS IN ACCOUNTING RESEARCH ON PROFESSIONAL RESPONSIBILITY AND ETHICS I...

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RESEARCH ON PROFESSIONAL RESPONSIBILITY AND ETHICS IN ACCOUNTING

RESEARCH ON PROFESSIONAL RESPONSIBILITY AND ETHICS IN ACCOUNTING Series Editor: Cynthia Jeffrey Recent Volumes: Volumes 1–5: Volumes 6–8: Volumes 9–11:

Series Editor: Lawrence Poneman Series Editor: Bill N. Schwartz Series Editor: Cynthia Jeffrey

RESEARCH ON PROFESSIONAL RESPONSIBILITY AND ETHICS IN ACCOUNTING VOLUME 12

RESEARCH ON PROFESSIONAL RESPONSIBILITY AND ETHICS IN ACCOUNTING EDITED BY

CYNTHIA JEFFREY Iowa State University, USA

Amsterdam – Boston – Heidelberg – London – New York – Oxford Paris – San Diego – San Francisco – Singapore – Sydney – Tokyo JAI Press is an imprint of Elsevier

JAI Press is an imprint of Elsevier Linacre House, Jordan Hill, Oxford OX2 8DP, UK Radarweg 29, PO Box 211, 1000 AE Amsterdam, The Netherlands 525 B Street, Suite 1900, San Diego, CA 92101-4495, USA First edition 2008 Copyright r 2008 Elsevier Ltd. All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without the prior written permission of the publisher Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford, UK: phone (+44) (0) 1865 843830; fax (+44) (0) 1865 853333; email: [email protected]. Alternatively you can submit your request online by visiting the Elsevier web site at http://www.elsevier.com/locate/permissions, and selecting Obtaining permission to use Elsevier material Notice No responsibility is assumed by the publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. Because of rapid advances in the medical sciences, in particular, independent veriﬁcation of diagnoses and drug dosages should be made British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN: 978-0-7623-1393-8 ISSN: 1574-0765 (Series) For information on all JAI Press publications visit our website at books.elsevier.com

Printed and bound in the United Kingdom 08 09 10 11 12 10 9 8 7 6 5 4 3 2 1

CONTENTS LIST OF CONTRIBUTORS

vii

EDITORIAL BOARD

ix

ESTABLISHING A STANDARDIZATION SAMPLE FOR ACCOUNTING STUDENTS’ DIT SCORES: A META-ANALYSIS Richard A. Bernardi and David F. Bean

1

INSTITUTIONAL OWNERSHIP AND CORPORATE POLITICAL ACTIVITY IN THE INSURANCE INDUSTRY: ETHICAL CONSIDERATIONS FOR ACCOUNTANTS Donna Bobek, Lois Mahoney and Robin W. Roberts

23

WHAT CONSTITUTES AN ACT DISCREDITABLE? AN EXPLORATORY STUDY Charlie Cullinan and Kathleen Simons

47

CAREER AMBITION VS. CONCERN FOR OTHERS: THE RELATIONSHIP OF PERSONAL VALUES TO EGREGIOUS ACCOUNTING AND FINANCIAL DECISIONS Frank Collins, Suzanne Lowensohn and Michael K. Shaub

71

CORPORATE GOVERNANCE SYSTEMS: AN ETHICS RESEARCH FRAMEWORK Steven M. Mintz v

101

vi

CONTENTS

WILL CORPORATE GOVERNANCE AND WHISTLEBLOWING PROVISIONS IMPROVE FINANCIAL RESPONSIBILITY? Tara J. Shawver and Todd A. Shawver

123

MANAGERIAL INTENT AND THE ETHICS OF EARNINGS MANAGEMENT Keith G. Stanga and Andrea S. Kelton

149

SELF-SERVING BIAS, RESPONDENT KNOWLEDGE, AND PERCEPTIONS OF NON-AUDIT SERVICES’ IMPACT ON AUDITOR INDEPENDENCE John M. Thornton, Alan Reinstein and Cathleen L. Miller

173

AN INSTRUCTIONAL CASE: GORDON TECHNOLOGIES INC. Steven M. Mintz and Roselyn Morris

203

LIST OF CONTRIBUTORS

David F. Bean

B. D. & C. Academic Consultants, New Rochelle, NY, USA

Richard A. Bernardi

Roger Williams University, Bristol, RI, USA

Donna Bobek

University of Central Florida, Orlando, FL, USA

Frank Collins

Texas A&M International University, Laredo, TX, USA

Charlie Cullinan

Bryant University, Smithﬁeld, RI, USA

Andrea S. Kelton

The University of South Florida, Tampa, FL, USA

Suzanne Lowensohn

Colorado State University, Fort Collins, CO, USA

Lois Mahoney

Eastern Michigan University, Ypsilsnti, MI, USA

Cathleen L. Miller

Wayne State University, Detroit, MI, USA

Steven M. Mintz

California Polytechnic State University, San Luis Obispo, CA, USA

Roselyn Morris

Texas State University, San Marcos, TX, USA

Alan Reinstein

Wayne State University, Detroit, MI, USA

Robin W. Roberts

University of Central Florida, Orlando, FL, USA vii

viii

LIST OF CONTRIBUTORS

Michael K. Shaub

Texas A&M University, College Station, TX, USA

Tara J. Shawver

King’s College, Wilkes-Barre, PA, USA

Todd A. Shawver

Lock Haven University of Pennsylvania, Lock Haven, PA, USA

Kathleen Simons

Bryant University, Smithﬁeld, RI, USA

Keith G. Stanga

The University of Tennessee, Knoxville, TN, USA

John M. Thornton

Washington State University, Richland, WA, USA

EDITORIAL INFORMATION Editor Cynthia Jeffrey Department of Accounting, College of Business, Iowa State University, IA, USA

Case Editor Steven M. Mintz California Polytechnic State University, San Luis Obispo, CA, USA

Editorial Review Board Mohammed Abdolmohammadi Bentley College

Charlie Cullinan Bryant College

Elizabeth Dreike Almer Portland State University

Stan Davis Indiana University – Purdue University Fort Wayne

Vicky Arnold University of Central Florida

F. Todd DeZoort University of Alabama

C. Richard Baker Adelphi University

Jesse Dillard Portland State University

Richard Bernardi Roger Williams University

Mary Doucet California State University Bakersfield

Susan Borkowski La Salle University ix

x

EDITORIAL INFORMATION

Dann Fisher Kansas State University

Kent St. Pierre University of Delaware

Timothy J. Fogarty Case Western Reserve University

Robin Radtke University of Texas at San Antonio

Marty Freedman Towson University

Sara Reiter SUNY-Binghampton

Karen Hooks Florida Atlantic University Steve Kaplan Arizona State University Julia Karcher University of Louisville Jim Lampe Missouri State University

Robin Roberts University of Central Florida Pamela Roush University of Central Florida Donald Samelson Colorado State University

Steve Loeb University of Maryland

Mike Schadewald University of WisconsinMilwaukee

Dawn W. Massey Fairfield University

Joe Schultz Arizona State University

Mark Mitschow SUNY College at Geneseo

John Sennetti Nova Southeastern University

Bruce Oliver Rochester Institute of Technology

Michael Shaub Texas A&M University

Carl J. Pacini Florida Gulf Coast University

L. Murphy Smith Texas A&M University

Michael A. Pearson Kent State University

Charles Stanley Baylor University

Editorial Information

xi

John Sweeney Washington State University

Carol Venable San Diego State University

Bill Thomas Baylor University

Paul Williams North Carolina State University

Linda Thorne York University

George Young Florida Atlantic University

John Thornton Washington State University The editors wish to thank the Editorial Board for the reviews they provided this year.

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ESTABLISHING A STANDARDIZATION SAMPLE FOR ACCOUNTING STUDENTS’ DIT SCORES: A META-ANALYSIS Richard A. Bernardi1 and David F. Bean ABSTRACT The goal of this study is to establish a standardization sample for accounting students’ P scores of Rest’s (1979a) Defining Issues Test (DIT). We examine the existing research in this area that includes the responses of 3,135 accounting majors. However, because many of the samples do not include P score data by gender, our final sample consisted of 1,635 students, which is 545 more responses (i.e., 51.4 percent larger) than Rest had in his standardization sample for the DIT. The final sample includes data from 13 states and thus responds to the problem with the generalizability of data from prior research. This research makes two important contributions to the literature by: (1) establishing a baseline for accounting students and (2) definitively establishing associations between DIT P scores and the critical variables of years of education and gender. It is important to note that this research is the first study in accounting that has examined the effect of a student’s class year (i.e., freshman, sophomore, junior or senior) on DIT P scores.

Research on Professional Responsibility and Ethics in Accounting, Volume 12, 1–21 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1574-0765/doi:10.1016/S1574-0765(07)00201-4

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RICHARD A. BERNARDI AND DAVID F. BEAN

The DIT (Rest, 1979a) is the prevalent instrument utilized in accounting research on ethics and values. For comparison purposes, the most frequently used benchmark to evaluate accounting students’ DIT P scores is Rest’s (1979b) standardization sample of 270 college students, which does not include accounting students. The status of our current stream of research using Rest’s original standardization sample has reached its limit especially given the number of published studies that examine accounting students’ P scores. The published and/or available data from researchers suggest that the next logical step in the evolution of our research should be to develop a broad sample of accounting majors’ DIT P scores for comparison purposes. The purpose of our research is to provide a benchmark that assesses the inﬂuence of gender and education on accounting majors’ DIT P scores. In this study, we examine the data from 13 studies, which disclose gender data, with a combined sample of 1,635 (780 male and 855 female accounting majors), which is six times the number of college students in Rest’s (1979b) standardization sample. Our sample is also geographically diverse; the 1,635 accounting majors represent universities and colleges located in 13 states. This paper makes two important contributions to the literature examining the moral development of accounting majors in the US, in that it establishes: (1) a baseline for accounting students and (2) associations between DIT scores with years of education and gender.

LITERATURE REVIEW Overview of the DIT Rest’s DIT is based on Kohlberg’s (1969) six-stage theory of moral development that is segmented into three general levels of moral thought – Pre-conventional Level, Conventional Level, and Post-conventional Level. The DIT generates a P score for an individual based on their level of ethical reasoning. A higher P score indicates that the respondent’s cognition is assimilating a higher proportion of Stage 5 and 6 considerations in their ethical-reasoning process. The P score is interpreted in terms of the relative importance that subjects place on the Post-conventional Level of moral reasoning, which consists of two stages – Stage 5: Social Contract Orientation and Stage 6: Ethical/Principle Orientation. An important characteristic of the P score for researchers is that it is a continuous variable that is ‘‘interpreted as the relative importance a subject gives to

Establishing a Standardization Sample for Accounting Students’ DIT Scores

3

principled moral considerations in making a decision about ethical dilemmas’’ (Rest, 1979b, Section 5, p. 2). The DIT measures a subject’s moral development (Rest, 1979b) by asking subjects to evaluate ethical dilemmas. Each dilemma is followed by 12 considerations that reﬂect moral reasoning at the upper ﬁve stage levels of moral development (i.e., the DIT does not include Stage 1 considerations). For each dilemma, individuals ﬁrst rate all considerations as having ‘great’, ‘much’, ‘some’, ‘little’, or ‘no’ importance in resolving the ethical dilemma. The participant then selects and ranks the four considerations he/she deems most important in resolving the dilemma. Each participant’s rankings determine their DIT P score, which reﬂects the percent of considerations ranked in the top four at Stages 5 and 6. The P scores on the DIT range from 0 to 90 (95) for the three (six) story version of the test. A score of zero (90) indicates that all ranked considerations are in the lower four (upper two) stage levels. Although most of the accounting research to date uses the original DIT, Rest and Narvaez (1998, p. 27) indicate that P scores for the DIT-2 correlate with the original DIT at 0.79 or approximately the test–retest reliability of the original DIT. While the level of research using the DIT-2 in accounting is not extensive, the similarity of scores between the original DIT and the DIT-2 suggest that our study would make a useful reference point.

Accounting Students and Ethics Research A major paradigm in accounting ethics research is based on Kohlberg’s stage theory of ethical development and the principal measurement instrument has been and continues to be the DIT P score (Bay & Greenberg, 2001). Some argue that US accountants tend to be rule-oriented (Ponemon, 1992; Lampe & Finn, 1992). Thus accounting students may exhibit an inherent bias towards Stage 4: Law and Order Orientation. For example, several early studies using the DIT found that the average P score of partners was much lower than the general population (Sweeney, 1995; Shaub, 1994; Ponemon & Gabhart, 1993; Ponemon, 1992). To explain their ﬁndings, they suggested that the selection–socialization process in public accounting resulted in retaining individuals with lower average P scores (Ponemon, 1992; Massey, 2002). However, Bernardi and Arnold (1997) show that these ﬁndings may be the result of using data from only one ﬁrm and a between-subjects research design. Additionally, Bernardi and Arnold

4

RICHARD A. BERNARDI AND DAVID F. BEAN

(2004, p. 362) refute prior ﬁndings concerning the selection–socialization process by showing that: The average DIT P-scores of the remaining auditors y were higher than those of the exiting auditors at each of the three data points for both male and female auditors; differential attrition did not occur over the 7.5-year period.

In the wake of the Enron crisis, the leaders of the Big 4 accounting ﬁrms have spoken out against a mentality of ‘‘following the rules’’ (e.g., Stage 4 reasoning). The managing partner of Deloitte & Touche stated that the accounting profession has ‘‘always strived to ‘follow the rules’, but in the wake of scandals and loss of investor confidence we obviously must do more to restore public trust’’ (Parrett, 2004). Similarly, the leaders of PricewaterhouseCoopers (2003) believe that restoring investor trust demands ‘‘transparency, accountability, and integrity’’ rather than just following the ‘‘letter of the law’’ (p. 3). Finally, the literature from KPMG (2003) maintains that the profession must prevent a ‘‘compliance mentality’’ from being the driving force in public accounting. These statements all acknowledge that ‘‘following the rules’’ has been accounting’s goal in the past; however, all suggest that a Stage 5/6 mentality is required to restore the public’s trust. This implies a movement towards a principles-based approach to auditing standards (Shortridge & Myring, 2004). Of major importance to both academics and practitioners are the recruitment, development, and retention of ethical personnel in the accounting profession. It may appear trite to ponder the importance of ethics to the accounting profession, which has such an overwhelming obligation to society as a whole; however, Lampe (1996) notes that there was little emphasis on discussion of ethics education by either practitioners or academics before the 1980s.

Establishing a Benchmark for Accounting Students There has been conﬂicting evidence on a number of issues with respect to P scores (e.g., gender effects, intervention effects, major ﬁelds of study effects, etc.). Many studies compare their P score results to the college students in Rest’s (1979b) standardization sample (Lampe, 1996; Fisher & Ott, 1996; Kite & Radtke, 1997). Some studies reference the P score results of other studies, with considerable diversity in terms of the details provided and studies referenced. We suggest that both of these approaches are limited.

Establishing a Standardization Sample for Accounting Students’ DIT Scores

5

We believe that merely comparing results to Rest’s 1979 standardization data is no longer tenable. As discussed in the preceding section of the study, the number, type, and geographic representation of subjects render a comparison to Rest only marginally useful. Furthermore, a comparison of P scores from a particular study to those in another study is arbitrary as the studies may include different class standing. The necessity of and beneﬁts from a benchmark for accounting students’ DIT P scores are obvious. We believe that the existing accounting literature contains sufﬁcient data to generate such a benchmark.

DIT P Score and Education Rest’s standardization sample includes 270 participants from each of four groups: junior high school students, senior high school students, college students, and college graduates. If one uses junior high school students as the base and then advances proportionally for each subsequent level of education (i.e., senior high school, college, and college graduates), Rest (1979b, p. 110) suggests an increase of 10 points in students’ P scores with each increasing level of education. In the United States, age and education are closely associated, which leads to the question of whether an increase in one’s DIT P score is dependent on age or education. For example, in a meta-analysis, Thoma (1984) found that age and education account for about 52 percent of the variation in DIT P scores. Even though age and education are associated, longitudinal data indicate that DIT P scores level off after formal education ends (Rest, 1986). Ponemon (1992) and Bernardi and Arnold (2004) conﬁrm the leveling off of DIT P scores after formal education using samples of practitioners from large public accounting ﬁrms. Consequently, education is the factor that enables growth in moral judgment. The data in Table 1 demonstrate the degree of similarity among Rest’s original standardization sample (Panel A), Rest’s secondary data (Panel B), and Thoma’s 1986 secondary data (Panels C and D), both of which can be found in Rest (1993). Panel A provides the data on Rest’s 1979 standardization sample that includes samples of 270 individuals taken from junior high school, senior high school, college, and college graduates. The data in all four of the panels indicate a clear progression of P scores with education, which is evident in the plots of these data in Fig. 1. Also evident is that the average P score for a given level of education did not vary with time.

6

RICHARD A. BERNARDI AND DAVID F. BEAN

Table 1. Standardization and Secondary Analysis Data. N

Group

P Score

Panel A: 1979 standardization sample (Rest, 1993, Section 3, p. 20) Junior high school students 270 Senior high school students 270 College students 270 College graduates 270

20.0 31.0 43.2 44.9

Panel B: 1979 secondary analysis (Rest, 1993, Section 3, p. 19) Junior high school students 1,322 Senior high school students 581 College students 2,479

21.9 31.8 42.3

Panel C: Men 1986 secondary analysis (Rest, 1993, Section 3, p. 19) Junior high school students 528 Senior high school students 424 College students 449

19.1 28.7 44.1

Panel D: Women 1986 secondary analysis (Rest, 1993, Section 3, p. 19) Junior high school students 519 Senior high school students 436 College students 436

19.8 30.4 45.9

Notes: The standardization and secondary analyses samples’ P scores are weighted averages for male and female students. No data provided for college graduates in secondary analyses.

DIT P Score

50 40 30 20 10 6

8

10

12

14

16

Years of Education

Fig. 1. Growth in DIT P Scores in the General Population. Rest’s Standardization Sample (1979) (Diamonds), Rest’s Secondary Analysis Data (1979) (Triangles), Thoma’s 1986 Meta-Analysis (Squares).

Assuming a uniform progression throughout college, an individual’s P score should increase at a rate of approximately three points per year. However, the problem is still that Rest’s data are now nearly 30 years old and represent only 270 college students. Consequently, we use Thoma’s 1986

Establishing a Standardization Sample for Accounting Students’ DIT Scores

7

Table 2. Weighted Least Squares Regression Models for DIT P Scores of Thoma’s Data. Model Regression

R2

Adjusted R2

Sum Weights

0.998

0.997

2,792

Source

df

Sum of Squares

F Factor

Probability F

Model Error Total

2 3 5

315,187.4 608.9 315,796.3

776.4

0.0001

Term

Coefﬁcient

T Statistics

P-value

4.57 4.32 0.67

4.89 39.39 2.50

0.0164 0.0001 0.0878

Intercept LEVEL GENDER LEVEL GENDER

Junior HS ¼ 6.5 Men ¼ 1

Senior HS ¼ 9.5 Women ¼ 0

Partial Adjusted R2 – 0.993 0.004 College ¼ 13.5

meta-analysis data (Panels C and D of Table 1) for the remainder of this paper. Not only is Thoma’s data more current, but the data include the responses of 885 (449+436) college students, which is over three times the number of college students in Rest’s standardization sample. To use the data in Panels C and D of Table 1, we assumed that all three levels of Thoma’s samples were evenly distributed between/among their inclusive grades. Thoma (2006) indicated that, in his 1986 meta-analysis, he classiﬁed seventh-and-eighth graders as junior high school students and ninth-to-twelfth graders as senior high school students. Consequently, junior high school students have an average of 6.5 years of education. Senior high school students have 9.5 years of education on average, and college students have 13.5 years of education on average. The weighted least squares regression for Thoma’s (1986) meta-analysis data (Panels C and D of Table 1) shown in Table 2 indicates that the LEVEL variable is signiﬁcant (po0.0001) and explains 99.3 percent of the variation (adjusted R2) between the means. While the model explains nearly all of the variation among the sample means, this does not imply the same explanatory power for the difference among persons. Rest, Narvaez, Bebeau, and Thoma (1999, p. 70) note that, although the effect size of education is the largest, education accounts for only 30–50 percent of the variation among persons.

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RICHARD A. BERNARDI AND DAVID F. BEAN

The GENDER variable is marginally signiﬁcant (p ¼ 0.0878) and explained only 0.4 percent of the variation in the model. Our analysis conﬁrms Rest’s (1993, Section 3, p. 20) observation that gender differences are ‘‘trivial on the DIT [P score and] accounting for less than 1/2 of a percent of DIT variance’’ for Thoma’s meta-analysis data. A cautionary note here is that the data set is comprised of only six average observations; however, these secondary data observations represent a combined sample of 2,792 students who are educationally quite diverse. The result of the analysis of Thoma’s data for the LEVEL variable suggests our ﬁrst research question: RQ1. Is there a difference in the average DIT P scores among college levels for accounting majors?

DIT P Score and Gender Table 3 provides a list of the 25 studies that incorporate DIT P scores using accounting majors with any ﬁndings that relate to gender differences and/or standardization sample differences.2 Of the 25 studies, 10 do not make comparisons with Rest’s sample or by gender; however, the remaining 15 studies include six comparisons with Rest’s sample and 9 comparisons by gender. Of the six studies that compare accounting majors to Rest’s standardization sample, the data indicate that the average DIT P score of Rest’s college sample (n ¼ 270) was higher than for accounting majors (Ponemon & Glazer, 1990; Icerman, Karcher, & Kennelly, 1991; Lampe, 1996; Fisher & Ott, 1996; Kite & Radtke, 1997). Contrary to Thoma’s ﬁnding of no gender difference and Rest’s (1993, Section 3, p. 20) observation that gender differences are ‘‘trivial on the DIT [P scores]’’, the data in Table 3 indicate a strong gender difference. In fact, of the nine studies that compared the DIT P scores by gender for accounting majors, eight (St. Pierre, Nelson, & Gabbin, 1990; Lampe & Finn, 1992; Shaub, 1994; Bernardi, 1995; Eynon, Hill, & Clarke, 1996; Fisher, 1997; Douglas & Schwartz, 1998; Bernardi, Downey, Massey, & Thorne, 2002) found that female accounting majors scored higher than male accounting majors. These differences suggest our second research question: RQ2. Is there a difference in the average DIT P scores between male and female accounting majors?

Establishing a Standardization Sample for Accounting Students’ DIT Scores

Table 3.

9

Overview of Prior Research.

Authors (Year)

Rest and/or Gender Comparisons

Kite and Radtke (1997) Fisher and Ott (1996) Lampe (1996) Jeffrey (1993) Icerman et al. (1991) Ponemon and Glazer (1990) Bernardi et al. (2002) Douglas and Schwartz (1998) Abdolmohammadi et al. (1997) Fisher (1997) Eynon et al. (1996) Bernardi (1995) Shaub (1994) Lampe and Finn (1992) St. Pierre et al. (1990) Bernardi et al. (2004) Fisher and Sweeney (2002) Massey (2002) Jeffrey and Ravenscoft (2001) Radtke (1999) Sweeney and Fisher (1999) Fisher and Sweeney (1998) Sweeney and Fisher (1998) Armstrong (1993) Ponemon (1993)

Rest W accounting (we computed) Rest W accounting Rest W accounting majors Consistent with Rest’s data Rest W undergraduates accounting Rest W AACSB; LA ¼ Rest Fa W Ma Fa W Ma Fa ¼ Ma; Accounting marginally W Rest Fa W Ma Fa W Ma Fa W Ma Fa W Ma, same as Rest’s data Fa W Ma, Rest W accounting Fa W Ma, no comparison No comparison No comparison No comparison No comparison No comparison No comparison No comparison No comparison No comparison No comparison

Note: Fa, Female; Ma, Male.

METHOD Samples Used in the Study Our initial sample is made up of the data from 25 prior studies that measured accounting majors’ level of moral development using the DIT (Rest, 1979a). This combined sample includes data from 3,135 accounting majors and is just over three times the size of Thoma’s (1986) meta-analysis sample of 885 college students. The data from Table 3 were divided into studies with available gender data (Table 4, Panel A) and those that did not include gender data (Table 4, Panel B). In the process of accumulating the studies used in this research, we requested data from the authors of all

Prior Research Sample Data.

Men

Women

Panel A: Studies with gender data Bernardi et al. (2004) Bernardi et al. (2002) Fisher and Sweeney (2002) Douglas and Schwartz (1998) Fisher and Sweeney (1998) Sweeney and Fisher (1998) Abdolmohammadi et al. (1997) Eynon et al. (1996) Fisher and Ott (1996) Bernardi (1995) Shaub (1994) Lampe and Finn (1992) St. Pierre et al. (1990)

115 94 106 298 112 137 94 95 182 113 91 129 69

58 48 46 133 52 66 44 44 87 69 41 69 23

57 46 60 165 60 71 50 51 95 44 50 60 46

Panel B: Studies without (w/o) gender Massey (2002) Jeffrey and Ravenscoft (2001) Radtke (1999) Douglas and Schwartz (1998) Kite and Radtke (1997) Fisher (1997) Lampe (1996) Armstrong (1993) Jeffrey (1993) Ponemon (1993) Icerman et al. (1991) Ponemon and Glazer (1990)

data 43 142 56 126 31 166 473 54 76 73 160 100

w/o w/o w/o w/o w/o w/o w/o w/o w/o w/o w/o w/o

w/o w/o w/o w/o w/o w/o w/o w/o w/o w/o w/o w/o

Fresh

F&S

Soph

S&J

Jun

J&S

Sen

115 94 106 298 112 137 94 95 182 113 91 129 69 43 85 31 126

57 25 31 166 144

329 54

10 46

88

76 73 62 54

RICHARD A. BERNARDI AND DAVID F. BEAN

N

Authors (Year)

10

Table 4.

Establishing a Standardization Sample for Accounting Students’ DIT Scores

11

studies that did not disclose it in their published data. While this increased the number of studies with gender data in Panel A, most of the older studies did not gather gender data for purposes of anonymity or the data had been deleted prior to our request. Table 4 data indicate the students’ college level at the time that the research was conducted: freshmen (Fresh), freshmen and sophomores (F&S), sophomores and juniors (S&J), juniors (Jun), juniors and seniors (J&S), and seniors (Sen). Bernardi (1995) notes that the average DIT P scores were signiﬁcantly different for senior accounting majors enrolled in auditing classes at three universities located in the Northeast. Bernardi found that educational differences prior to college were not a factor. As all three samples were equivalent, potential causes of the differences include curriculum emphasis and self-selection bias. As a result, authors of accounting research commonly include a limitation that the sample came from only one or two schools and may not be generalizable to the population as a whole. Consequently, we believe that using a meta-analysis (Wolf, 1986) provides more generalizable results than a single study. The studies in our database that include gender data (Table 4, Panel A) came from colleges/universities located in 13 states: Connecticut, Illinois, Iowa, Kansas, Massachusetts, Missouri, Nebraska, New York, Rhode Island, Texas, Vermont, Virginia, and Washington. While some of the colleges and universities draw their students from essentially one state, many of the universities and colleges represented in this group draw students from a wider regional and/or national pool. Although the effect of size lessens after a point (see Table 2; T-statistic and power), the samples in our study provide a broader scope than Thoma’s (1986) meta-analysis sample of 885 college students for comparison purposes. As indicated in Panel A of Table 4, all the studies provide data at either one level or data averaged for two college levels (i.e., F&S). For example, while nine of the samples stratify their participants by speciﬁc college year, ﬁve studies have samples whose DIT P scores were averaged for a combined sample of F&S (Bernardi, Bean, & Massey, 2004; Eynon et al., 1996) or juniors and seniors (Fisher & Sweeney, 2002, 1998; Sweeney & Fisher, 1999). Consequently, we have 13 groups of students in our initial data set; we also divide each of these samples by gender so that our ﬁnal data includes 26 groups (Table 5). Although our ﬁnal sample has only 26 data points, these studies include the responses of 1,635 accounting majors (780 men and 855 women), which is about twice (six times) as large as Thoma’s (Rest’s) meta-analysis (standardization) sample of 885 (270) college students.

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Table 5.

RICHARD A. BERNARDI AND DAVID F. BEAN

DIT P Score by Year Group for Studies with Gender Data.

Authors (Year)

Total

Men

Women

N

DIT P

N

DIT P

182 113 91 129 69 584

87 69 41 69 23 289

36.4 41.8 38.3 34.0 38.6 37.6

95 44 50 60 46 295

38.5 47.6 48.3 39.0 45.8 42.8

Panel B: Combined senior & junior data Fisher and Sweeney (2002) 106 Fisher and Sweeney (1998) 112 Sweeney and Fisher (1998) 137 355

46 52 66 164

35.7 37.4 36.7 36.6

60 60 71 191

36.7 38.6 38.8 38.1

48 133 181

32.7 36.9 35.8

46 165 211

38.4 40.2 39.8

58 44 102

27.3 28.9 28.0

57 51 108

29.8 35.8 32.6

94

44

31.7

50

34.8

1,635

780

35.4

855

39.3

Panel A: Senior data Fisher and Ott (1996) Bernardi (1995) Shaub (1994) Lampe and Finn (1992) St. Pierre et al. (1990)

Panel C: Junior data Bernardi et al. (2002) Douglas and Schwartz (1998)

94 298 392

Panel D: Combined sophomore & freshman data Bernardi et al. (2004) 115 Eynon et al. (1996) 95 210 Panel E: Freshman data Abdolmohammadi et al. (1997) Overall Totals/Averages DIT P – Data are weighted means Weighted overall mean

37.44

Methodological Challenge A problem we encountered in the research was that some of the studies used the three-story version and others used the six-story version of the DIT. Because there were more studies that used the six-story version, we adjusted the scores of the studies that used the three-story version of the DIT. An adjustment was made because the highest score on the three (six) story version is 90 (95). This difference is caused by the number of Stages 5 and 6 considerations in each dilemma. While each dilemma in the three-story version only has three Stage 5 or 6 considerations, the additional three

Establishing a Standardization Sample for Accounting Students’ DIT Scores

13

dilemmas in the six-story version each have four Stage 5 or 6 considerations. To allow us to adjust for this difference, we made the following assumption: The proportion of Stages 5 and 6 considerations an individual selects on the three-story version would be the same as the proportion he/she would select on the additional three scenarios of the six-story version.

Consequently, the scores for the studies that used the three-story version of the DIT must be increased by a factor of 1.056 (95/90) to estimate an individual’s score on the six-story version of the DIT. For example, a score of 40.0 on the three-story version becomes an estimated score of 42.2 (40.0 1.056) for the six-story version of the DIT.

RESULTS Descriptive Statistics The detail of DIT P scores by gender and class year is reported in Table 5. Table 5 data conﬁrms this general notion that DIT P scores increase as accounting students spend more time in institutions of higher education. For all of the 13 studies, the average DIT P score for female students is higher than that of male students. Indeed, Table 5 indicates that female accounting majors score 3.9 (39.335.4) points higher on the DIT than male accounting majors. Panel A of Fig. 2 shows the data for both the general population (Thoma, 1986) and for accounting students (current data). The plots indicate that the data for the general population are approximately ﬁve points higher than that for accounting students if the growth in moral development (as measured by the DIT) is constant since junior high school (i.e., the earliest observations for the general population). The data in Panel B of Fig. 2 depicts the differences in DIT P scores between levels and genders during college for accounting majors. The nearly parallel lines suggest similar growth rates during college with male students being three (ﬁve) points below female students at entry (graduation) – level means from Table 5 (Panels A and E).

Data Analysis To determine the inﬂuence of gender and class year on DIT P scores, we used a weighted least squares regression (Table 6), which is appropriate

14

RICHARD A. BERNARDI AND DAVID F. BEAN 50 DIT P Score

(A)

40 30 20 10 6

8

10

12

14

16

Years of Education (B)

DIT P score

50 40 30 20 10 12

13

14

15

16

Years of Education

Fig. 2. Growth in DIT P Scores in the General Population and Accounting. Panel A, Thoma’s Meta-Analysis (Squares) and Accounting Majors (Diamonds); Panel B, Male (Triangles) and Female (Circles) Accounting Majors.

whenever the sample sizes are not the same (Lipsey & Wilson, 2001, p. 106). Because larger (smaller) samples have more (less) precise means, we use a study’s sample size as our weighting factor in the analysis. The weighted least squares regression for the current data indicates that both the LEVEL and GENDER variables are signiﬁcant and that the model explains 57.8 percent of the variation (e.g., adjusted R2) in the data set. A student’s level in college explains 40.2 percent of the variation and is signiﬁcant (po0.0001). The coefﬁcient of the level variable indicates that a student’s P score should increase 3.12 points for each of the three years between Fresh and Sen levels. The gender variable was also signiﬁcant (p ¼ 0.003) and explained an additional 17.6 percent of the variation in the model, which is signiﬁcantly higher than what Rest (1993, Section 3, p. 20) refers to as ‘‘trivial on the DIT [P score and] accounting for less than 1/2 of a percent of DIT variance’’. The coefﬁcient of the gender variable indicates that male students have a

Establishing a Standardization Sample for Accounting Students’ DIT Scores

Table 6.

15

Weighted Least Squares Regression Model for DIT P Score. R2

Adjusted R2

Sum Weights

0.612

0.578

1,635

Model Regression Source

df

Sum of Squares

F Factor

Probability F

Model Error Total

2 23 25

20,513.6 12,999.0 33,512.6

18.15

0.0001

Term

Coefﬁcient

T Statistics

P-value

Partial Adjusted R2

Intercept LEVEL GENDER LEVEL

29.39 3.12 3.91 Fresh ¼ 0 Sen ¼ 3.0 Men ¼ 1

13.93 5.06 3.32 S&F ¼ 0.5

0.0001 0.0001 0.0030 Jun ¼ 2

– 0.402 0.176 J&S ¼ 2.5

GENDER

Women ¼ 0

P score that is 3.91 points lower than female students, which is 10.4 percent of the 37.44 overall weighted average P scores for the entire sample from Table 5.

Meta-Analysis A concern of researchers is whether or not their results can be replicated using different samples (i.e., are generalizable). As more research is done in an area, the ability to test the robustness of a ﬁnding is enhanced especially if all researchers use common metrics. Hunter, Schmidt, and Jackson (1982, p. 26) indicate that the problem researchers initially encountered was ﬁnding a method to examine the: ‘‘results from existing studies to reveal patterns of relatively invariant underlying relations and causalities, the establishment of which will constitute general principles and cumulative knowledge.’’ Meta-analysis procedure provides a ‘‘rigorous alternative to the causal, narrative discussion of research studies’’ (Glass, 1976, p. 3) for researchers to examine the existent literature. It follows the normative belief that, as the number of studies with similar ﬁndings increases, the robustness of that ﬁnding increases. Meta-analysis is a method of summing the results (i.e., the ‘t’ or ‘z’ statistics) and obtaining a statistic for comparison. This statistic is larger than a straight average because it is computed by dividing by the

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RICHARD A. BERNARDI AND DAVID F. BEAN

square root of N (or degrees of freedom) in the Stouffer (Winer) combined test (Wolf, 1986, pp. 19–20). We use the tests in this section of the analysis (Wolf, 1986, pp. 18–39) to conﬁrm the robustness of our estimates from the previous section. In our analysis (Table 6), we note that the GENDER variable had an estimated coefﬁcient of 3.91 and was signiﬁcant (p ¼ 0.0030). Using the procedures described in Wolf for meta-analyses, we found that GENDER was signiﬁcant (p ¼ 0.0002) using the Fisher, Stouffer, and Winer combined tests (18–23) for summarizing the results of independent tests of the same hypothesis. Our data included only published work; perhaps, one of the reasons gender differences were not published in several studies is that they were not signiﬁcant. Indeed, studies with non-signiﬁcant ﬁndings are usually not publishable; this is referred to as the ‘‘File Drawer Problem’’ (Wolf, 1986, p. 37). To test the robustness of our ﬁndings, we also computed the ‘‘fail-safe N’’ (Wolf, 1986, pp. 37–39), which is the number of studies with non-signiﬁcant ﬁndings it would take to reverse our conclusion that Gender associates with DIT P scores. Our data indicate that, at the 0.05 level (0.01 level), it would take an additional 117 (52) studies with non-signiﬁcant gender differences to reverse our conclusion. As we found no studies that examined grade level, we tested for differences in grade levels by comparing each of the studies at the senior level (e.g., Panel A of Table 5) against all of the studies for the four grade levels below seniors (e.g., combined J&S, Jun, combined F&S, and Fresh). We then examined the differences for all of studies at the combined J&S level against all of the studies for the three grade levels below the combined J&S (e.g., Jun, combined F&S, and Fresh), which resulted in 63 comparisons. Using the same procedures we used for GENDER, we found that LEVEL was signiﬁcant (p ¼ 0.0001) using the Fisher, Stouffer, and Winer combined tests. To test the robustness of our ﬁndings, we also computed the ‘‘fail-safe N,’’ which is the number of studies with non-signiﬁcant ﬁndings it would take to reverse our conclusion that LEVEL associates with DIT P scores. Our data indicate that, at the 0.05 level (0.01 level), it would take an additional 9,312 (4,610) studies with non-signiﬁcant level differences to reverse our conclusion.

Additional Analysis The data used in the primary study came from colleges and/or universities located in 13 states: Connecticut, Illinois, Iowa, Kansas, Massachusetts, Missouri, Nebraska, New York, Rhode Island, Texas, Vermont, Virginia,

Establishing a Standardization Sample for Accounting Students’ DIT Scores

17

50

DIT P score

40

30

20

10 6

8

10

12

14

16

Years of Education

Fig. 3. DIT P Scores for All 25 Accounting Studies Compared to Thoma’s Data. Thoma’s 1986 Meta-Analysis (Squares), Accounting Majors (25 Studies) (Diamonds).

and Washington. The data from the other studies increase the number of states to 16 by adding: California, Georgia, and Pennsylvania. While 16 states is only 32 percent of the total number of states, the total population of these states represents 51.1 percent of the population of the United States (Internet Public Library, 2005). The dispersion by population ranking of our sample includes 6 of the top 10 states, 4 of the second 10, and 2/3/2 for the other groups.3 The data for the 13 studies used for the analysis do not signiﬁcantly differ from the overall data for all 25 studies (Table 4). Fig. 3 shows the plot for all 25 accounting studies and conﬁrms our ﬁndings of a difference in the DIT level of accounting majors and the Thoma’s 1986 meta-analysis data of the general population (Fig. 2).

DISCUSSION This research makes two important contributions to the literature by: (1) establishing a baseline for accounting students and (2) deﬁnitively establishing association between DIT scores and the critical variables of years of education and gender. It is important to note that, to our knowledge, this research is the ﬁrst study in accounting that has examined the effect of a student’s class year (i.e., Fresh, sophomore, Jun or Sen) on DIT P scores. The issue of the impact of gender on DIT P scores has been inconsistently addressed and reported in the literature. Some studies report a signiﬁcant

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RICHARD A. BERNARDI AND DAVID F. BEAN

difference while others do not, and many studies either do not control for gender or do not report results by gender. The summary results analyzed in our study support, rather conclusively, the position that female accounting majors have a signiﬁcantly higher average DIT P scores than male accounting majors. While Rest and Thoma ﬁnd no signiﬁcant gender difference, the accounting literature typically reports gender differences between male and female participants. While one study does not produce deﬁnitive results, this study uses the data from 13 prior studies, which include a sample of 1,635 college students. Our data indicate that female accounting majors scored signiﬁcantly higher on the DIT. The effect of a student’s class year (i.e., Fresh, sophomore, Jun or Sen) on DIT P scores has not been examined in any literature to date except the current study. Our study shows that there is an increase in the DIT P score of 3.12 points for every increase in class year. This increase is slightly below the average growth rate of 4.32 points per year for Thoma’s (1986) metaanalysis sample. While some may argue that the DIT P score increases as a result of taking liberal arts courses, the data reported in Table 4 cannot conﬁrm this. The quantity and/or quality of liberal arts courses are not controlled for in any of these studies. Furthermore, the class year(s) when most liberal arts courses are taken are not reported for the empirical results used in our sample studies. Some might argue that examining the scores of accounting students and/or recent graduates limits the usefulness of a study because it does not address the moral development of professionals. However, the literature indicates that one’s growth in moral development levels off immediately after one’s formal education ends unless a signiﬁcant intervention occurs (Rest, 1979b, p. 143). Indeed, Bernardi and Arnold (2004) make this no-growth point in public accounting in a longitudinal study. Consequently, the level of moral development of our graduates is what we would expect for our professionals. A potential limitation of this research is that it uses data for the original DIT and not the DIT-2. However, Rest and Narvaez (1998, p. 27) indicate that P scores for the DIT-2 correlate with the original DIT at 0.79 or approximately the test–retest reliability of the original DIT. Consequently, the scores on the DIT-2 appear to be comparable to scores on the original DIT.

NOTES 1. The authors are involved in several research projects and alternate lead author responsibilities; both authors contribute equally to all of their published work.

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2. We did not use the Bay and Greenberg data in the analysis because of the small sample size (n ¼ 45). Their sample is divided into six different groups (i.e., three levels and two genders at each level), which ranged in size from 12 to 4. 3. It is important to note that our data set is constrained by the geographic locations of those colleagues who publish ethics research.

REFERENCES Abdolhomammadi, M. J., Gabhart, D. R. L., & Reeves, M. F. (1997). Ethical cognition of business students individually and in groups. The Journal of Business Ethics, 16(16), 1717–1725. Armstrong, M. B. (1993). Ethics and professionalism in accounting education: A sample course. Journal of Accounting Education, 11(1), 77–92. Bay, D., & Greenberg, R. (2001). The relation of the DIT and behavior: A replication. Issues in Accounting Education, 16(3), 367–380. Bernardi, R. A. (1995). Ethics research in accounting: A note on using the deﬁning issues test. Accounting Educators’ Journal, 7(2), 1–16. Bernardi, R. A., & Arnold, D. F., Sr. (1997). An examination of moral development within public accounting by gender, staff level and ﬁrms. Contemporary Accounting Research, 14(4), 653–668. Bernardi, R. A., & Arnold, D. F., Sr. (2004). Testing the ‘‘Inverted-U’’ phenomenon in moral development on recently promoted senior managers and partners. Contemporary Accounting Research, 21(2), 353–367. Bernardi, R. A., Bean, D. F., & Massey, D. W. (2004). The inﬂuence of political ideology on DIT scores: Fact or artifact? Research on Accounting Ethics, 9, 21–48. Bernardi, R. A., Downey, A., Massey, D. W., & Thorne, T. (2002). Critical thinking and moral reasoning of intermediate accounting students. Research on Accounting Ethics, 8, 73–102. Douglas, P. C., & Schwartz, B. N. (1998). A longitudinal study of the effect of teaching ethics throughout the accounting curriculum. Research on Accounting Ethics, 4, 89–112. Eynon, G., Hill, N., & Clarke, P. (1996). An international comparison of moral reasoning abilities: Accounting students from Ireland and the United States. Journal of Accounting Education, 14(4), 477–492. Fisher, D. G. (1997). Assessing taxpayer moral reasoning: The development of an objective measure. Research on Accounting Ethics, 3, 141–171. Fisher, D. G., & Ott, R. L. (1996). A study of the relationship between accounting students’ moral reasoning and cognitive style. Research on Accounting Ethics, 2, 51–72. Fisher, D., & Sweeney, J. (1998). The relationship between political attitudes and moral judgment: Examining the validity of the deﬁning issues test. Journal of Business Ethics, 17(8), 905–916. Fisher, D. G., & Sweeney, J. T. (2002). Morality vs. ideology: Implications for accounting ethics research. Advances in Accounting Behavioral Research, 5, 141–160. Glass, G. (1976). Primary, secondary, and meta-analysis research. Educational Researcher, 5(10), 3–8. Hunter, J. E., Schmidt, F. L., & Jackson, G. B. (1982). Meta-analysis: Cumulating research findings across studies. Beverly Hills, CA: Sage Publications.

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Icerman, R., Karcher, J., & Kennelly, M. (1991). A baseline assessment of moral development: Accounting, other business and nonbusiness students. Accounting Educator’s Journal, 4(2), 46–62. Internet Public Library. (2005). States ranked by size and population. Available online from: http://www.ipl.org/youth/stateknow/popchart.html. Jeffrey, C. (1993). Ethical development of accounting students, non-accounting business students, and liberal arts students. Issues in Accounting Education, 8(1), 86–96. Jeffrey, C. G., & Ravenscoft, S. P. (2001). Rule observance attitudes and ethical development of accounting and non-accounting business students. Research on Accounting Ethics, 7, 1–18. Kite, D., & Radtke, R. R. (1997). The effect of moral reasoning levels and political ideology on environmental accounting education. Research on Accounting Ethics, 3, 173–189. Kohlberg, L. (1969). Stages and sequences: The cognitive developmental approach to socialization. In: D. Goslin (Ed.), Handbook of socialization theory and research. Chicago: Rand McNally. KPMG. (2003). Audit committee roundtable highlights. Available online from: http:// www.kpmg.com Lampe, J. C. (1996). The impact of ethics education in accounting curricula. Research on Accounting Ethics, 2, 187–220. Lampe, J. C., & Finn, D. W. (1992). Reply. Auditing: A Journal of Practice and Theory, 11(Suppl), 68–73. Lipsey, M. W., & Wilson, D. B. (2001). Practical meta-analysis. In: Applied social research methods series (Vol. 49). Thousand Oaks, CA: Sage Publications. Massey, D. W. (2002). The importance of context in investigating auditors’ moral abilities. Research on Accounting Ethics, 8, 195–247. Parrett, W. G. (2004). Globalization’s next frontier: Principled codes of conduct bolster the rule of law. Speech to International Center for Corporate Accountability, United Nations, May 17. Available online from: www.socialfunds.com/news/release.cgi/2740.html. Ponemon, L. (1992). The ethical reasoning and selection–socialization in accounting. Accounting, Organizations and Society, 17(3/4), 543–563. Ponemon, L. (1993). Can ethics be taught in accounting? Journal of Accounting Education, 11(2), 185–209. Ponemon, L., & Gabhart, D. R. L. (1993). Ethical reasoning in accounting and auditing. Research Monograph no. 21, CGA-Canada Research Foundation, Vancouver. Ponemon, L., & Glazer, A. (1990). Accounting education and ethical development: The inﬂuence of liberal learning on students and alumni in accounting practice. Issues in Accounting Education, 5(2), 195–208. PricewaterhouseCoopers. (2003). Understanding the independent auditor’s role in building public trust: A white paper. PricewaterhouseCoopers International. Radtke, R. R. (1999). A experimental evaluation of the inﬂuence of moral reasoning on escalation errors. Advances in Accounting Behavioral Research, 2, 101–125. Rest, J. R. (1979a). In: Defining issues test. Center for the Study of Ethical Development, Minneapolis, MN: University of Minnesota Press. Rest, J. R. (1979b). Development in judging moral issues. Minneapolis, MN: University of Minnesota Press. Rest, J. R. (1986). Moral development: Advances in research and theory. New York: Praeger.

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Rest, J. R. (1993). Guide for the defining issues test. Minneapolis, MN: Center for the Study of Ethical Development. Rest, J. R., & Narvaez, D. (1998). Guide for DIT-2. Minneapolis, MN: Center for the Study of Ethical Development. Rest, J. R., Narvaez, D., Bebeau, M. J., & Thoma, S. J. (1999). Postconventional moral thinking: A neo-Kohlbergian approach. Mahwah, NJ: Lawrence Erbaum. Shaub, M. K. (1994). An analysis of the association of traditional demographic variables with the moral reasoning of auditing students and auditors. Journal of Accounting Education, 12(1), 1–26. Shortridge, R. T., & Myring, M. (2004). Deﬁning principles-based accounting standards. The CPA Journal, 74(8), 34–37. St. Pierre, E. K., Nelson, E., & Gabbin, A. (1990). A study of the ethical development of accounting majors in relation to other business and non-business disciplines. Accounting Educators’ Journal, 3(1), 23–35. Sweeney, J. (1995). The moral expertise of auditors. Research on Accounting Ethics, 1, 213–234. Sweeney, J., & Fisher, D. (1998). An examination of the validity of a new measure of moral judgment. Behavioral Research on Accounting, 10, 139–158. Sweeney, J., & Fisher, D. (1999). Politics, faking, and self-presentation: How valid is the P score of the deﬁning issues test. Research on Accounting Ethics, 5, 51–75. Thoma, S. J. (1984). Estimating gender differences in the comprehension and preference of moral issues. Unpublished manuscript, University of Minnesota, MN. Thoma, S. J. (2006). Personal telephone conversation between the lead author and Thoma on October 13, 2006 at 6:15 p.m. Wolf, F. M. (1986). Meta-analysis: Quantitative methods for the research synthesis. Newbury Park, CA: Sage Publications.

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INSTITUTIONAL OWNERSHIP AND CORPORATE POLITICAL ACTIVITY IN THE INSURANCE INDUSTRY: ETHICAL CONSIDERATIONS FOR ACCOUNTANTS Donna Bobek, Lois Mahoney and Robin W. Roberts ABSTRACT In this study, we extend prior research on institutional ownership by investigating the relationship between the presence and concentration of institutional owners and the political activity of insurance companies during the development and passage of the United States’ Taxpayer Relief Act of 1997. We rely on prior research on both institutional ownership (Kochhar & David, 1996; Wahal, 1996; David, Hitt, & Insead, 2001) and corporate political activity (Hillman & Hitt, 1999; Freed & Swenson, 1995) to motivate our study and develop our empirical models. Our study provides initial evidence of the association between institutional ownership and corporate political activity. In particular, the observed positive relationship between institutional ownership and levels of corporate political activity are consistent with the active investor view of institutional owners. We argue that there are related ethical considerations for accountants concerning these activities. For example, accountants should be concerned Research on Professional Responsibility and Ethics in Accounting, Volume 12, 23–46 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1574-0765/doi:10.1016/S1574-0765(07)00202-6

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with the extent to which performance demands of institutional owners pressure them to consider or make questionable decisions regarding their involvement in political activities. Accountants and accounting policymakers should have similar concerns in regard to the extent to which their corporate political activity regarding tax law benefits their shareholders to the detriment of the broader society. Furthermore, the results of this study add to accountants’ understanding of the political process, helping to improve corporate decision making.

Institutional investors (e.g., public and union pension funds and mutual funds) have become a dominant force in the United States equity market (Varma, 2001; Ryan & Schneider, 2002). Their dominance has attracted the interest of both the popular press (e.g., Fortune, 1999; Wall Street Journal, 2000) and academic researchers (e.g., Velury & Jenkins, 2006; Ajinka, Bhojraj, & Sengupta, 2005; Bradshaw, Bushee, & Miller, 2004; Bushee, 2001; David, Kochhar, & Levitas, 1998; Johnson & Greening, 1999; Wahal, 1996; Kochhar & David, 1996; Hill, Hitt, & Hoskisson, 1988; Porter, 1992). Both literatures raise a public interest concern regarding the institutional investors’ ability to exert inﬂuence on the corporate managers of their portfolio corporations (e.g., Smith, 1996; Useem, 1993; Johnson & Greening, 1999; Ryan & Dennis, 2003). Commentators, as well as prior research results, differ on whether this inﬂuence has a positive or negative effect. Some argue that institutional investors look mainly for short-term gains, and this puts undue pressure on ﬁrm managers to maintain a high current stock price (Graves, 1988; Graves & Waddock, 1990; Kochhar & David, 1996) even at the expense of long-term ﬁrm value. Others, however, argue that institutional owners are focused on long-term ﬁrm value and are either better at picking investments that have good long-term prospects (e.g., Kochhar & David, 1996; Allen, 1993; Jensen, 1988), or use their power to inﬂuence ﬁrm managers to make decisions that enhance the long-term prospects of the ﬁrm (Useem, 1993; Kochhar & David, 1996; Ryan & Schneider, 2002). Concurrent with this ongoing debate regarding how and whether institutional investors have a positive inﬂuence on ﬁrm managers and long-term ﬁrm value (Graves, 1988; Kochhar & David, 1996; Bushee, 2001), a related concern exists regarding the inﬂuence that corporations and industry groups exert on government regulation and tax policy (e.g., Grier, Munger, & Roberts, 1994; Suarez, 1998; Roberts & Bobek, 2004; Oberman, 2004). Due to their large wealth endowments, corporations are able to exert

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inﬂuence on politicians by engaging in a variety of costly political activities including lobbying and making political action committee (PAC) contributions (Hillman & Hitt, 1999; Oberman, 2004). Roberts and Bobek (2004) detail the inﬂuence of two industries, the airline and insurance industries, on the Taxpayer Relief Act of 1997 (1997 Act). Signiﬁcant resources were expended by these industries in a relatively successful attempt to shape the ﬁnal outcome of this tax legislation. Just as prior research has found that institutional investors have been successful at inﬂuencing ﬁrm managers regarding other issues such as research and development (R&D) expenditures (Kochhar & David, 1996), expenditure of resources on political activities designed to inﬂuence tax policy may also have a direct link to the long-term value of the ﬁrm. This study extends prior institutional investor research (Useem, 1993; Kochhar & David, 1996; Wahal, 1996; David et al., 2001) by exploring the relationship between institutional ownership and the political activity of corporations. Our investigation draws on the work of Roberts and Bobek (2004) and considers the political activities of ﬁrms in the insurance industry during the policy formulation stage of the 1997 Act. The accounting profession is intimately involved in issues of corporate governance, such as the role and inﬂuence of institutional investors, and in issues of corporate political activity. Financial accounting information produced by corporate accountants is often viewed as a major factor in corporate governance (Bushman & Smith, 2001). Accounting decisions regarding earnings management also have been linked to institutional investors’ ownership level in a ﬁrm (Jiambalvo, Rajgopal, & Venkatachalam, 2002). Prior research shows that both public accounting ﬁrms (Roberts, Dwyer, & Sweeney, 2003; Dwyer & Roberts, 2004) and corporations (Freed & Swenson, 1995; Roberts & Bobek, 2004; Barber, Johnson, & Petroni, 2007; Cho, Patten, & Roberts, 2006) make campaign contributions to federal legislators as part of a corporate political strategy that helps determine laws that inﬂuence the determination of accounting and/or tax policies. We choose to study the relationship between institutional ownership and corporate political activity in the particular context of the insurance industry’s political activities surrounding the 1997 Act for several reasons. First, we have speciﬁc evidence that the insurance industry was at least partially successful at inﬂuencing the ﬁnal structure of the 1997 Act (Roberts & Bobek, 2004). Second, the policy formulation stage of the 1997 Act spanned a ﬁnite time period: a six-month period in 1997 that ended in early August. Third, the insurance industry was identiﬁed (Roberts & Bobek, 2004) as the single biggest contributor to both political parties for

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the time period in question. Finally, the insurance industry has a sufﬁcient number of ﬁrms to allow us to perform empirical tests. Thus, we investigate the link between the political activity of insurance companies during the policy formulation stage of the 1997 Act and the presence and concentration of two sets of institutional owners in those companies. Speciﬁcally, we examine this relationship for all institutional owners, and then for only the public pension fund owners (Wahal, 1996). Our analysis of public pension fund ownership is motivated by prior work that asserts that these funds should be the most active of all institutional investors (Ryan & Schneider, 2002; Ryan & Dennis, 2003). The empirical ﬁndings support the notion that there is a positive association between the level of active institutional investors that hold ownership in a corporation and in that corporation’s level of political activity. We did not, however, ﬁnd this relationship to be stronger in the case of public pension funds. The results of this study provide several important contributions. First, we extend the understanding of the ethical considerations that accountants and accounting and tax policymakers may encounter during periods of potential tax legislation. Second, as one of the primary objectives of accounting is to provide information useful to decision makers, it is important for accountants to understand the impact of institutional investors and corporate political activity on the ﬁrms’ long-term value to ensure that they are providing relevant and timely information to decision makers. Finally, we relate our ﬁndings to the appropriateness of corporations’ involvement in the development of public policy. The remainder of the chapter is organized as follows. First, we discuss prior research regarding institutional investors and corporate political activity and present our research questions. Second, we explain our research method and third, we present the results. Finally, we discuss our conclusions.

PRIOR RESEARCH Institutional Investors The increasing wealth and the concentration of this wealth in fewer institutions are reﬂective of the growing dominance of institutions in the capital market (Brancato & Gaughan, 1991; Albrecht & Sack, 2001). The percentage of corporate equity held by institutional investors has increased from 16% in the 1960s to more than 57% by the year 2000 (Ryan & Schneider, 2002). Prior research focusing on institutional investors

Institutional Ownership and Corporate Political Activity

27

(e.g., Kochhar & David, 1996) has advanced three competing theories of the goals of institutional owners. First, the myopic view of institutional owners argues that they focus excessively on the short-term performance of ﬁrms. Because some institutional investor managers are evaluated quarterly and are under pressure to report higher earnings, they may focus on performance measures, like current earnings, that are easily quantiﬁable (Graves & Waddock, 1990). Thus, these institutional investor managers frequently turn over their portfolio of stock in order to capitalize on shortterm stock price changes (Loescher, 1984; Shleifer & Vishny, 1990), even if the changes are only temporary.1 Graves (1988) cites increased trading volume associated with increases in the percentage of shares owned by institutional investors as potential evidence of short-term trading by institutional investors. Bushee (2001) identiﬁes certain transient institutional investors to also have a preference for short-term performance. This argument suggests that institutional owners may prefer to proﬁt from portfolio shufﬂing when there are increases or decreases in stock prices, rather than focus on long-term value from their investment decisions. Knowing that investors are preoccupied with short-term results may cause corporate managers to enhance short-term stock performance at the expense of long-term growth and survival. Critics of the myopic view of institutional owners advance several arguments. First, in response to a ﬁrm’s poor ﬁnancial performance, institutional owners’ high aggregate ownership makes it difﬁcult for them to sell off their shares, as doing so may adversely affect the stock price, potentially making the sale unattractive (David et al., 1998; Pound, 1988). Second, it is difﬁcult for institutional investors to ﬁnd new proﬁtable alternative investments because they already tend to be well diversiﬁed and own signiﬁcant stakes in most ﬁrms in the economy (David et al., 1998). Finally, institutional owners who do not prefer ﬁrms that invest for long-term gains are systematically undervaluing expected earnings (Jarrell, Lehn, & Marr, 1985; Jensen, 1988). In order to execute a long-term investment strategy, institutional owners may become active investors (Kochhar & David, 1996). The active investor view of institutional ownership purports that institutional owners use their ‘voice’ to influence2 managerial decisions of ﬁrms in which they presently invest (Holdderness & Sheehan, 1988; Hoskisson, Johnson, & Moesel, 1994). Empirical research supports this view. Holdderness and Sheehan (1988) found that block shareholders are usually directly involved in ﬁrm management and do not merely monitor management teams, but lead them. Brickley, Lease, and Smith (1988) found that the average institutional

28

DONNA BOBEK ET AL.

investor was more likely to vote and get involved in ﬁrm decisions than the average noninstitutional shareholder because of their higher investment in the ﬁrm. Furthermore, Demsetz and Lehn (1985) reported that ownership positions of 0.5% are sufﬁcient to inﬂuence corporate outcomes. Davis and Thompson (1994) suggested that the increase in institutional investors’ aggregate equity holding constitutes a new social movement. Although single institutional investors may not have large blockholdings, they can gain power from coordinated action through their joint holdings to inﬂuence the decisions of corporate managers including whether or not to engage in political activities designed to inﬂuence pending legislation. The Council of Institutional Investors is the result of the formation of shareholder institutional investors and provides a springboard for collective action (Davis & Thompson, 1994). Institutions are increasingly resorting to activity to press their demands on corporate managers (David et al., 1998). These pressure tactics have been successful as evidenced by ﬁrms that have changed compensation packages in response to institutional demands (Star, 1993). David et al. (2001) also present evidence that institutional investors do actively inﬂuence ﬁrm managers to increase R&D expenditures. Other researchers have focused on the association between the presence and concentration of institutional investors and accounting information. Koh (2003) investigating institutional investors in Australia found evidence of a role for both transient and long-term-oriented institutional investors regarding the presence of earnings management strategies. He found evidence of aggressive earnings management in corporations with transient institutional investors, but higher institutional ownership levels were associated with long-term-oriented institutional investors that limited managerial accrual discretion. Ajinka, Bhojraj, and Sengupta (2005) show that companies with greater institutional ownership are more likely to issue forecasts and that the forecasts are more accurate. Velury and Jenkins (2006) ﬁnd a positive association between institutional ownership and earnings quality. Johnson and Greening (1999) disaggregated institutional investors into two groups: pension funds and investment management funds. They argue that pension fund owners are long-term investors that are much more likely to be concerned with the long-term value of the ﬁrm. Johnson and Greening (1999) found that pension fund ownership is positively related to corporate social performance, but found no relationship between other institutional owners and corporate social performance. Wahal (1996) also investigated pension fund activism. She identiﬁed nine major public pension funds3 and studied the types of issues they targeted for activism. She found a

Institutional Ownership and Corporate Political Activity

29

considerable variation in the types of issues targeted by these public pension funds. Although the majority of targeted issues related to proxy proposals (e.g., board composition, voting rules, and poison pills), as opposed to performance issues, there was a notable increase in performance-related targeting over the sample time period (1987–1993). Del Guerico and Hawkins (1999) investigated ﬁve of the same funds as Wahal (1996) over the same time period. They concluded that public pension funds are more successful at monitoring and promoting change in target ﬁrms than previously recognized ﬁrms and that less public forms of activism (e.g., private letters and phone calls to management) increased over the time period they investigated. Ryan and Dennis (2003) and Ryan and Schneider (2002) predict that of all institutional investors, public pension funds managers are likely to engage in the most shareholder activism. The characteristics of public pension plans that lead them to this conclusion include large equity holdings, predictable time horizons for their outﬂows which lead them to develop a long-term perspective regarding investments (evidenced by low asset turnover), freedom from the interference and dependence on the private sector (or in Ryan and Schneider parlance they are ‘‘pressure resistant’’), and relative freedom from government regulation.

Corporate Political Activity In this chapter, we focus on the investments that insurance companies make in political activities and what relationship, if any, these activities have to the number and concentration of institutional investors in these ﬁrms. Corporations tend to become engaged directly in state politics when they realize that their particular interests in the business/state relationship are threatened by speciﬁc policy deliberations (Suarez, 2000). During the public policy formulation stage (i.e., when legislation is being actively debated), corporations advance their goals by undertaking activities such as lobbying public policymakers and making PAC contributions to politicians (Buchholz, 1988; Mack, 1997). Corporations lobby public policymakers to communicate their views to legislators regarding proposed legislation. These activities provide a corporation with the opportunity to provide legislators with their reasons for adopting a particular position on proposed legislation and to try and inﬂuence policy outcomes (Mack, 1997; Hillman & Hitt, 1999). Corporations may augment their political activities through coordination with trade associations and/or advocacy coalitions (Mizruchi, 1992;

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DONNA BOBEK ET AL.

Mack, 1997; Suarez, 1998; Hojnacki, 1998). Trade associations typically represent a broad spectrum of industry membership. These types of associations (e.g., the American Institute of Certiﬁed Public Accountants) are most likely to be politically active during policy formulation when its members have similar concerns over proposed legislation (Roberts et al., 2003; Mack, 1997; Hillman & Hitt, 1999). Prior research has studied PAC contributions made from a variety of industries including defense (Fleisher, 1993), ﬁnancial services (Kroszner & Stratmann, 1998; Romano, 1997), and trucking (Frendreis & Waterman, 1985). In this context, corporations and coalitions use PAC contributions strategically in an attempt to inﬂuence the legislators most important to them (Grier, Munger, & Torrent, 1990). We choose to focus speciﬁcally on corporate political activity regarding tax legislation because of its direct link to ﬁrm proﬁts. Prior research shows that tax policy affects the business decisions of corporations (Vines & Moore, 1996) and that corporations engage in intersocial interest, intra-industry and inter-ﬁrm political conﬂict (Jacobs, 1987, 1988; Quinn & Shapiro, 1991; Suarez, 1998; Roberts & Bobek, 2004) in hopes of reducing their ﬁrms’ overall tax burden (Mizruchi, 1992). In particular, Quinn and Shapiro (1991) examined several hypothetical relationships among taxation, redistribution, politics, and business/class power. They found a signiﬁcant relationship between increases in the general level of campaign ﬁnancing from the corporate sector and lower overall corporate tax burdens. Roberts and Bobek (2004) found evidence that the insurance industry and airline industry actively engaged in political activities (lobbying, PAC contributions, and soft money contributions) designed to inﬂuence the structure of the 1997 Act. Speciﬁcally, they found that insurance and airline companies that lobbied lawmakers about the 1997 Act also made signiﬁcantly more PAC contributions to lawmakers who were on the taxwriting committees of their respective chambers, than they did to other lawmakers. These companies were also relatively successful in shaping the provisions of the 1997 Act that directly affected the long-term proﬁts of the industry. The insurance industry, in particular, was interested in a number of complex tax provisions, and in total spent almost 30 million dollars on political activities.4 Roberts and Bobek (2004) detail many of the speciﬁc tax issues of interest to the insurance industry.5 There was a wide range of complex tax provisions that were targeted by the insurance industry. These interests ranged from provisions that would have a direct effect on after-tax net

Institutional Ownership and Corporate Political Activity

31

income, such as a provision to extend favorable treatment of foreign sourced income to insurance companies, to provisions that while not directly affecting the tax liability of insurance ﬁrms would have a direct or indirect effect on their costs of doing business or demand for their products, for example, how receipts from a 4.5% federal highway tax would be spent. They also advanced speciﬁc positions on tax provisions targeted at individuals because if the provisions were adopted, they could have repercussions (both positive and negative) for their business. For example, the industry favored an increase in the deductibility of health insurance for self-employed taxpayers because it would make health insurance more affordable. On most issues, the insurance industry’s lobbying was not a total success. For instance, they only received a one-year reprieve from the unfavorable treatment of foreign sourced income. However, Roberts and Bobek (2004) convincingly showed that the industry was able to exert inﬂuence over most of the provisions of interest. The present study extends the work of Roberts and Bobek (2004) by investigating the association between the concentration of institutional owners of insurance companies and the amount of political activity (speciﬁcally lobbying and PAC contributions) engaged in by these insurance ﬁrms. We believe this investigation is important to accounting researchers for at least two reasons. First, there are ethical concerns regarding the extent to which corporations use their large wealth endowments to inﬂuence the democratic process (Oberman, 2004). Accountants, as part of the corporate leadership team, are intimately involved in corporations’ decisions to engage in political activity and in institutional investors’ decisions to encourage such participation. This is especially true when the legislation under consideration is related to tax or accounting. Second, and related to our ﬁrst reason, in recent years Congress has become much more involved in legislating accounting activities (e.g., Sarbanes–Oxley, the establishment of the public company accounting oversight board (PCAOB), etc.). The purpose of this legislation has been to safeguard the public interest. To the extent that corporations are successful in political activities designed to protect the corporations’ interests as opposed to the public interest, the objectives of the legislation may not be achieved. Thus, it is important to consider the extent to which corporations are involved in political activities designed to inﬂuence tax and accounting legislation. For example, prior research has documented corporate political activity regarding the development of legislation regarding tax laws (Freed & Swenson, 1995; Roberts & Bobek, 2004), environmental disclosures (Cho et al., 2006), auditor litigation reform (Roberts et al., 2003), accounting for stock

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DONNA BOBEK ET AL.

options (Barber et al., 2007), and the Sarbanes–Oxley Act of 2002 (Thornburg & Roberts, 2007). This chapter focuses on a particular aspect of this investigation, namely the role that institutional investors may play in encouraging, or at least in supporting these activities, as they relate to tax legislation.

RESEARCH QUESTIONS Like R&D expenditures and corporate social performance, corporate political activity is a discretionary activity that does not have a direct link to near-term proﬁts. Roberts and Bobek (2004) showed that the insurance industry, in particular, engaged in costly political activities that were at least somewhat successful in preserving or enhancing future after-tax income. They also expressed concern that the large amounts of money spent on these activities contributed to structural inequities in the tax policy-making process. Thus, the central research questions of this chapter are: RQ1. Is the presence of institutional investors and the magnitude of their ownership interest related to corporate political activities? RQ2. If so, is this effect more pronounced with regard to public pension funds which are argued to be the most active of all institutional investors? Positive evidence regarding both of these questions would provide further support for the active investor view of institutional investors and would also provide additional input into the debate about whether institutional investors are a positive or negative force in the ﬁnancial markets. If ﬁrm senior managers and accountants are more politically active because of institutional ownership pressures, then these executives should consider the ethical dimensions of their actions.

METHODOLOGY Data and Sample The sample of insurance ﬁrms for this study was initially drawn from the Standard & Poor’s Research Insight. We identiﬁed 190 companies that had insurance standard industrial classiﬁcation (SIC) codes and 1996 and 1997 ﬁnancial data. We obtained institutional investor data from the

Institutional Ownership and Corporate Political Activity

33

CDA/Spectrum Institutional Stock Holdings Series for 1996. Missing institutional investor data reduced the sample size to 140 useable observations.

Corporate Political Activity Measures PAC contributions and lobbying expenses were used as measures of corporate political activity (Hillman & Hitt, 1999). We focus on PAC contributions and lobbying expenses, not because they are the only types of political activity, but because they are the most visible, and quantiﬁable. We gathered lobbying reports and PAC contribution data for the insurance industry for the period relevant to the policy formulation stage of the 1997 Act. The lobbying and political contribution activities relevant to the public policy formulation stage of the 1997 Act occurred between the time the 1997 Act was originally introduced (as the Revenue Reconciliation Act) during January 1997 until its passage on August 5, 1997 (Roberts & Bobek, 2004). Lobbying reports are ﬁled with the Clerk of the House of Representatives and the Secretary of the Senate on a semi-annual basis. Therefore, we gathered reports for all insurance-related ﬁrms for the January–June 1997 reporting period. These mandatory ﬁlings specify whether or not a ﬁrm was engaged in lobbying activities during this period and whether any were related to the 1997 Act. We only included lobbying expenses for ﬁrms that identiﬁed the 1997 Act in their report. PAC contributions are reported to the Federal Election Commission and compiled by the Center for Responsive Politics, for each election cycle. Thus, we collected PAC contributions made by corporations to congressmen and senators for the election cycle (1997–1998) which included the time period that the 1997 Act was being debated. While the lobbying reports speciﬁcally stated whether or not the company paying for the lobbying was attempting to inﬂuence the 1997 Act, we do not have the same level of knowledge regarding the PAC contributions. The 1997 Act may have been one of the many reasons why the PAC contributions were made. Therefore, the link between the PAC contributions made during the 1997–1998 election cycle, and the direct enhancement of long-term ﬁrm value via inﬂuencing tax legislation, is not as theoretically strong as it is for the lobbying expenses. Nevertheless, since lobbying and making ﬁnancial contributions are ﬁrms’ most visible and effective activities during the policy formulation stage of proposed legislation (Mack, 1997; Hillman & Hitt, 1999), we include PAC contributions as one measure of political activity.

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DONNA BOBEK ET AL.

Institutional Investor Measures Data for the institutional investor variables were obtained from the CDA/ Spectrum 13(f) Institutional Stock Holdings for December 31, 1996. This time frame was chosen because it is these institutional owners who would have the ability to inﬂuence management to engage in political activity during the policy formulation stage of the 1997 Act. We collected ﬁve institutional investor measures: the number of institutional investors owning shares, the percentage of equity owned by institutional investors, the number of shares owned by public pension fund managers (see Note 3), the number of public pension funds owning shares, and the percentage of equity owned by the public pension funds. Most prior research has focused on the percentage of equity owned either by all institutional investors (e.g., Bushee, 2001; David et al., 1998; Kane & Velury, 2004) or by pension funds (e.g., Johnson & Greening, 1999; McGuire, Dow, & Argheyd, 2003; David et al., 2001). Graves and Waddock (1994) also considered the number of institutional owners.

Regression Model The conceptual regression model used to explore our research questions is given in the following equation: Political activity ¼ Institutional ownership þ Firm size þ Prior period political activity

ð1Þ

This model is adapted from Freed and Swenson (1995), who analyzed PAC contributions during two earlier tax reform periods. Their test variables were tax-related variables because they had ﬁrms from a variety of industries. They used current year sales and sales squared as their ﬁrm size controls. However, using sales squared presents multicollinearity problems; therefore, we only use sales revenues in 1997 as the control for ﬁrm size. They also controlled for prior period PAC contributions as they observed a serial trend in these contributions. We use PAC contributions for the 1995–1996 election cycle as our control for prior political activity in all four models (even when lobbying is the political activity variable). Because we use a lobbying expense variable related speciﬁcally to the 1997 Act as our test variable, there is no direct prior year expense we can use as a control.6

Institutional Ownership and Corporate Political Activity

35

RESULTS Descriptive Statistics and Correlation Analysis Table 1 reports descriptive statistics and the correlation matrix for our data. The average sales for the companies in our data set are $3.2 billion. Institutional investors own approximately 48% of the outstanding shares, although the public pension funds only own an average of 3.5% of outstanding shares. There is a signiﬁcant correlation between the number of institutional investors, the number of public pension fund owners, the number of public pension fund shares outstanding, and the political activity variables (i.e., lobbying expenses and PAC contributions). However, the percentage of shares owned by institutional investors is only correlated with lobbying expenses; and the percentage owned by public pension funds is not correlated with any of the political activity variables. Sales are signiﬁcantly correlated with the political activity variables, the number of institutions owning shares, and the number of public pension fund shares. Table 2 reports the results of t-tests showing the difference in the variables of interest for politically active insurance ﬁrms versus those insurance ﬁrms that are not politically active. Forty-six of the ﬁrms in our sample made PAC contributions during the 1997–1998 election cycle. These ﬁrms were about 10 times larger than the insurance companies that did not make PAC contributions, were owned by almost three times as many institutional owners and public pension funds, and had 58% of their outstanding shares owned by institutional investors. The average amount of PAC contributions for ﬁrms that did contribute was $71,206. Only 18 of the insurance ﬁrms in our sample reported lobbying expenses. However, the average lobbying expense was over $314,000; and the lobbying ﬁrms were 5 times larger than the ﬁrms that did not lobby. As with the PAC contributing ﬁrms, all of the institutional ownership variables, except for the public pension fund ownership percentage, were signiﬁcantly different between the lobbying ﬁrms and the non-lobbying ﬁrms.

Regression Analysis Institutional Investors Table 3 presents the results of our regression analysis using all institutional investors as our ‘‘test’’ variable. Four separate regressions were run because we had two speciﬁcations of the dependent variable, political

36

Table 1.

Descriptive Statistics and Pearson Correlation Matrix with Institutional Ownership and Lobbying Expenses, PAC Contributions, and Sales.

Variable

*po.01

Standard Deviation

97.04 48.3% 3.78 1175 3.45% $20,863 $23,075 $36,025 $3,186

111.5 27.4 3.10 2332 3.32 63,815 78,581 137,423 7,794

1

2

3

4

5

6

7

8

.490* .759* .869* .254* .397* .328* .605* .391*

.652* .341* .243* .146** .066 .221* .017

.607* .612* .319* .265* .318* .175*

.232* .436* .333* .651* .417*

.104 .060 .045 .040

.755* .592* .415*

.419* .339*

.441*

DONNA BOBEK ET AL.

Number of institutions owning shares, 1996 Percent shares owned by institutions, 1996 Number of public pension funds Public pension fund shares (in thousands) Percent shares owned by activist pension funds PAC contributions (1997–1998 cycle) PAC contributions (1995–1996 cycle) Lobbying expenses Sales 1997 (in millions)

Mean

Institutional Ownership and Corporate Political Activity

Table 2.

37

Comparison of Politically Active Insurance Firms and Non-Politically Active Insurance Firms.

Number of politically active insurance ﬁrms Mean (S.D.) PAC/lobbying expense of politically active ﬁrms Mean (S.D.) Number of institutions owning shares (12/31/96) Insurance ﬁrms with political activity Insurance ﬁrms with no political activity Mean (S.D.) % shares owned by institutional owners (12/31/96) Insurance ﬁrms with political activity Insurance ﬁrms with no political activity Mean (S.D.) Number of public pension funds owning shares (12/31/96) Insurance ﬁrms with political activity Insurance ﬁrms with no political activity Mean (S.D.) Number of public pension fund shares – in thousands (12/31/96) Insurance ﬁrms with political activity Insurance ﬁrms with no political activity Mean (S.D.) % shares owned by public pension funds (12/31/96) Insurance ﬁrms with political activity Insurance ﬁrms with no political activity Mean (S.D.) sales (in millions) (FY97) Insurance ﬁrms with political activity Insurance ﬁrms with no political activity

PAC

Lobbying Expense

46 $71,206 ($102,241)

18 $314,214 (284,159)

185.2 (142.5)* 60.7 (69.2)

278.13 (169.11)* 74.4 (77.27)

57.6% (.27)* 44.5% (.25)

64.5% (.23)* 46.3% (.27)

6.3 (2.6)* 2.7 (2.6)

7.13 (2.2)* 3.36 (2.9)

2,983 (3,600)* 423 (679)

5,046 (4,736)* 687 (1147)

4.54% (.026)* 3.00% (.035) 8,774 (12,477)* 901 (2,199)

4.26% (.020) 3.34% (.034) 10,825 (8,196)* 2,183 (7,188)

*Signiﬁcantly different from that of ﬁrms with no political activity at p-value o.01.

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DONNA BOBEK ET AL.

Table 3.

Institutional Investors (IO) CPA=b0+b1IO+ b2Sales+b3Prior Year CPA. Dependenta

Independent Variables Lobby expense Testb Number of institutional owners Percent shares owned Control Sales 1997 PAC contributions 1996 Model statistics R2 F N

Lobby expense

.482**c

PAC PAC contributions contributions

.133* .215**

.176** .199** .454 38.25** 141

.340** .286** .313 20.94** 141

.109* .135* .664** .606 70.82** 141

.182** .684** .604 70.09** 141

*po.05; **po.01. a Lobbying expenses are the amount of lobbying expenses reported from January 1997 through June 1997 related to the 1997 Act. PAC contributions are the amount of contributions to Federal House and Senate members during the election cycle related to the 1997 Act. b Number of institutional owners is the number of institutions that held shares in each company at the end of 1996. Percent shares owned is the percentage of outstanding shares held by institutional owners at the end of 1996. c Standardized regression coefﬁcient.

activity (lobbying expenses and PAC contributions), and two speciﬁcations of the institutional ownership variable (number of institutional investor managers and the percentage of shares owned by institutional investors). As shown in Table 3, regardless of the speciﬁcation, institutional ownership is signiﬁcant at explaining both lobbying expenses (p-valueo.01) and PAC contributions (p-valueo.05) controlling for size and prior political activity. Both of the control variables, 1997 sales and prior period PAC contributions were signiﬁcant as well. These results are consistent with the active investor view of institutional owners. We performed several sensitivity analyses to gain additional conﬁdence in our results. When sales are replaced with assets as the ﬁrm size control, the results are the same as reported in Table 3. Since the dependent variables, lobbying expense and PAC contributions both contain many zero values, ordinary least squares regression analysis may not produce accurate results. Therefore, we also re-ran each of the analyses reported in Table 3 using a censored regression (Tobit) model. The signiﬁcance of the variables reported

Institutional Ownership and Corporate Political Activity

39

in Table 3 was unchanged. Thus, our ﬁndings do not appear to be driven by model speciﬁcations. In the next section, we focus our tests speciﬁcally on the extremely active institutional investors’ (Ryan & Dennis, 2003) public pension funds. Public Pension Funds The descriptive statistics shown in Table 1 suggest that public pension funds are not large investors in insurance companies. While, on average, 48.3% of the outstanding shares of ﬁrms in our sample were owned by institutional investors, only 3.45% of the outstanding shares were owned by public pension funds. We repeated our analysis using the number of public pension fund managers and the percentage of shares owned by public pension funds as the test variables. The results of these regressions are reported in Table 4. Table 4.

Public Pension Fund (PF) Investors CPA=b0+b1PF+ b2Sales+b3Prior Year CPA. Dependenta

Independent Variables Lobby expense Testb Number of public pension fund owners % shares owned by pension funds Control Sales 1997 PAC contributions 1996 Model statistics R2 F N

Lobby expense

.205**c

PAC PAC contributions contributions

.120* .043

.310** .257** .305 20.07** 140

.333** .300** .268 16.76** 140

.073 .165** .666** .605 69.95** 140

.182** .687** .597 67.67** 140

*po.05; **po.01. a Lobbying expenses are the amount of lobbying expenses reported from January 1997 through June 1997 related to the Taxpayer Relief Act of 1997. PAC Contributions are the amount of contributions to Federal House and Senate members during the election cycle related to the Taxpayer Relief Act of 1997. b Number of pension fund owners is the number of public pension funds (out of the nine identiﬁed by Wahal 1996) that held shares in each company at the end of 1996. Percent shares owned is the percentage of outstanding shares held by these public pension funds at the end of 1996. c Standardized regression coefﬁcient.

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DONNA BOBEK ET AL.

The results for public pensions fund ownership are somewhat mixed. While the number of public pension funds owning shares was signiﬁcantly related to corporate political activity expenditures (both for lobbying and PAC contributions), the percentage owned was not signiﬁcant. Table 2 shows that ﬁrms that were politically active had a higher public pension fund ownership percentage (e.g., the ﬁrms that made PAC contributions had 4.54% of their shares owned by public pension funds, while the ﬁrms that did not make PAC contributions only had 3% of their shares owned by public pension funds); however, after controlling for previous year’s political activity and ﬁrm size, the variable was not a statistically signiﬁcant one.

Discussion In this chapter, we addressed two research questions. First, we investigated whether the presence and magnitude of institutional investors is related to the level of insurance ﬁrms’ corporate political activity. The results reported in Tables 2 and 3 suggest the answer to this question is ‘‘yes.’’ Regardless of the speciﬁcation of the institutional ownership variable, the political activity variable, and the control variables, the level of institutional ownership is related to the level of political activity of the insurance ﬁrms in our sample. These results are consistent with the active investor view of institutional investors. The second question we asked is, given the fact that public pension funds have been identiﬁed as the most ‘‘active’’ of all institutional investors, is this effect more pronounced with regard to these public pension funds? At least in the case of insurance ﬁrm political activities, the results in Table 4 suggest ‘‘no.’’ Even though the number of pension fund owners is signiﬁcant in the regression, and Table 2 presents evidence that politically active ﬁrms have higher public pension fund ownership than non-politically active ﬁrms, the percentage of shares owned by public pension funds is not statistically signiﬁcant in the regression reported in Table 4. Thus, these regression results, along with the small ownership percentages on average, suggest that public pension funds are not more inﬂuential than other institutional owners with regard to insurance ﬁrms’ political activities.

LIMITATIONS We realize the limitations of our research. We cannot generalize our conclusions beyond the insurance industry or during periods of other legislation.

Institutional Ownership and Corporate Political Activity

41

In addition, as stated previously, we do not presume to explain exactly how this inﬂuence takes place. Prior research has identiﬁed a number of different mechanisms of this inﬂuence including direct pressure placed on executives via personal communication (Wall Street Journal, 2000; Holdderness & Sheehan, 1988) and activity at shareholder meetings (e.g., Star, 1993); perceived pressure felt by heightened expectations and oversight by institutional investors and/or latent power of institutional investors to constrain choices (Chaganti & Damanpour, 1991). However, we believe that this research provides a ﬁrst step toward understanding the relationship between corporate political activity and institutional ownership. Finally, we are also aware that lobbying and making PAC contributions are not the only activities ﬁrms undertake to inﬂuence policymakers. They are, however, the most visible and easily quantiﬁable political activities.

CONCLUSION AND FUTURE RESEARCH This study was undertaken to investigate the relationship between institutional ownership and the political activities of insurance ﬁrms during the policy formulation stage of the 1997 Act. We identiﬁed a signiﬁcant relationship between the level of institutional ownership at the end of 1996 and the level of political activity during the policy formulation stage of the 1997 Act which took place during a six-month period which ended on August 5, 1997 (when the act was passed), after controlling for ﬁrm size and prior political activity. These results were robust to different speciﬁcations of the dependent, control, and test variables. Thus, there appears to be strong evidence in favor of the active investor view advanced by Kochhar and David (1996). Speciﬁcally, these results suggest that ﬁrms that have larger institutional investor ownership are more likely to participate in the political process during the debate of relevant tax legislation, presumably in hopes of maintaining or increasing proﬁtability of the ﬁrm. The understandings of these ﬁndings are important to accountants to ensure they take into account the actions of their institutional stakeholders when making ﬁrm decisions. Future research will beneﬁt from an examination of the speciﬁc processes by which managerial actions, strategic outcomes, and performance are inﬂuenced by institutional investors. Further, these results extend the corporate political activity literature (e.g., Hillman & Hitt, 1999) by documenting the relationship between institutional investors and corporate political activity. Also, given our sample of insurance ﬁrms with relatively

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small public pension fund ownership stakes, we were not able to adequately determine the role that public pension funds may play in (non-insurance) ﬁrms’ choices to engage in political activity. Thus, future research should consider other industries with higher public pension fund ownership in order to address this issue. Finally, the results of this study are important from a public interest perspective. Kochhar and David (1996) argue that evidence in favor of the active investor view indicates that institutional investors are a positive inﬂuence on ﬁrm managers. While this may be true when only considering the long-term value of the ﬁrm, the effect on the political environment should not be ignored. Roberts and Bobek (2004) detailed the efforts of the insurance industry to use its substantial wealth endowment to shape the 1997 Act, and concluded that their success at doing so was the evidence of structural inequities in the federal tax policy-making process. The extent to which other powerful interests (e.g., institutional investors) inﬂuenced the industry to engage in political activities is additional evidence of these inequities. Prior research has shown that large corporations use their political inﬂuence to beneﬁt their shareholder to the detriment of the broader society (Roberts & Bobek, 2004) and that institutional pressures to meet earnings targets can negatively inﬂuence ﬁnancial reporting decisions. These same institutional pressures may negatively affect decisions regarding corporate political activities such as those that are undertaken to lobby for advantageous tax law changes. Thus, in pursuing their own political agenda inﬂuenced by institutional investors, corporation may support public policy decisions that harm other segments of society (Roth, 2002). Accountants in these ﬁrms should consider the ethical dimensions of their activities. Future research that considers the precise nature of this inﬂuence would be useful.

NOTES 1. Theoretically, all publicly available information should be embedded in the stock price, and thus the price should reﬂect the future beneﬁt of current period investments in long-term earnings such as research and development expenditures and corporate political activity. Kochhar and David (1996) suggest, however, that these sorts of expenditures can depress stock prices in the short run if investors are over-weighting information such as current earnings when making their investment decisions. 2. Throughout this chapter we use the term ‘‘inﬂuence.’’ However, we do not presume to address how this inﬂuence takes place. The inﬂuence could be merely in

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the form of pressure felt by managers to perform. For example, the knowledge that institutional investors are focused on the long-term value of the ﬁrm may lead managers to adopt new strategies to help them meet heightened performance expectations. On the other hand, the inﬂuence could be direct. There is evidence that institutional investors have access to ﬁrm managers (Wall Street Journal, 2000), present proposals at shareholder meetings (Star, 1993; Wahal, 1996), and may be directly involved in other managerial decisions (Holdderness & Sheehan, 1988). Chaganti and Damanpour (1991) suggest, however, that institutional owners only have ‘‘latent’’ power, which they describe as the power to constrain choices. When we refer to ‘‘inﬂuence’’ we mean any or all of these activities. 3. The pension funds she investigated were the California Public Employees’ Retirement System, the California State Teachers’ Retirement System, the Colorado Public Employees’ Retirement System, the New York City Pension System, the Pennsylvania Public School Employees’ Retirement System, the State of Wisconsin Investment Board, the College Retirement Equities Fund, the Florida State Board of Administration, and the New York State Common Retirement System. 4. This ﬁgure includes lobbying expenditures, PAC contributions, and ‘‘soft money’’ contributions to political parties by insurance ﬁrms (both mutual and stock ﬁrms) and insurance industry associations. Since institutional investors are the focus of the present study, we only consider the subset of these ﬁrms that are publicly traded. 5. The airline industry was primarily interested in one issue: the structure of a federal surtax on airline tickets (Roberts & Bobek, 2004). The conﬂict over whether the tax would be a per-segment tax or a percentage tax pitted seven major airlines (which spent much more on political activity) against smaller low-fare carriers. Although the major airlines were not completely successful in their lobbying efforts, they were successful enough for the Wall Street Journal to label them as one of the ‘‘Big Winners’’ of the 1997 Act. 6. PAC contributions and lobbying expenses are signiﬁcantly correlated. The correlation coefﬁcient between these variables as shown in Table 1 is .356, which is signiﬁcant at the .01 signiﬁcance level. Therefore, while not a perfect control for prior lobbying expense, we believe it is an adequate proxy.

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WHAT CONSTITUTES AN ACT DISCREDITABLE? AN EXPLORATORY STUDY Charlie Cullinan and Kathleen Simons ABSTRACT Various professional and regulatory bodies prohibit Certified Public Accountants (CPAs) from performing ‘‘acts discreditable to the profession.’’ However, a clear and consistent definition of these ‘‘acts discreditable’’ is not available in either the AICPA Code of Professional Conduct or the various state codes of conduct. Because of the potential for the profession as a whole to be harmed by discreditable acts, we seek to examine CPA professionals’ perceptions of what kind of actions may constitute discreditable acts. This examination is effected by a survey in which CPAs are asked to indicate whether they feel particular acts may be discreditable to the profession. Acts in three categories were examined: (1) acts performed by CPAs in their client-service capacity, (2) acts by CPAs outside of client-service, but in a business/finance capacity, and (3) acts of CPAs in their personal lives. The results indicate that there is general agreement that inappropriate acts performed in a CPA’s client-service role are discreditable. Acts committed by CPAs outside of their client-service role, but in a business/ finance area, were generally viewed as being discreditable by the majority

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of respondents. CPAs’ perceptions of acts performed in the CPA’s personal life varied depending on the moral intensity of the act. For personal-life issues of higher moral intensity (e.g., manslaughter caused by drunk driving), a majority of CPAs viewed these acts as discreditable. For personal-life issues of lower moral intensity (e.g., having an extramarital affair), most respondents did not view these types of acts as discrediting the profession.

INTRODUCTION Various codes and regulations governing public accounting practice, including The American Institute of Certiﬁed Public Accountants (AICPA), Code of Professional Conduct (Code of Conduct), and various state boards of accountancy prohibit Certiﬁed Public Accountants (CPAs) from engaging in acts discreditable to the profession. However, the authoritative guidance on what constitutes an ‘‘act discreditable to the profession’’ is limited and inconsistent among the states. Texas, for example, considers acts involving ‘‘moral turpitude’’ to discredit the profession, while the AICPA (2006) code is silent on moral turpitude issues. The research on the issue of ‘‘acts discreditable to the profession’’ (e.g., Stanley, 2004; McGee, 1998a) is fairly limited, and most of this research has been non-empirical in nature. The objective of our chapter is to determine whether there is a degree of consensus among CPAs on what types of actions may discredit the profession. To examine this issue, we developed a series of 15 short scenarios involving potentially discreditable acts. These scenarios ranged from misappropriating funds for which one is a trustee to speeding 5 miles over the speed limit. We then surveyed CPAs to determine whether they felt the various scenarios represented ‘‘acts discreditable to the profession.’’ Overall, our 275 CPA respondents felt that actions most closely related to a CPA’s client-service work were more likely to be discreditable than those actions that do not relate to a CPA’s core services. We also found that CPAs working in public accounting and those working in business and industry had similar perceptions of acts discreditable. The chapter begins with some background and a review of the relevant literature, a discussion of states’ roles, followed by the development of our research questions. We then describe the research methods employed, report the results, draw conclusions, and state the limitations and suggestions for future research.

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BACKGROUND, LITERATURE REVIEW, AND RESEARCH QUESTIONS In this section, we ﬁrst brieﬂy discuss the nature of professional codes, and how ‘‘acts discreditable’’ provisions ﬁt into these codes. We then explore the AICPA’s ‘‘acts discreditable’’ rules, and the existing literature on these rules. This is followed by a discussion of various state rules, and potential sanctions for those considered to have committed a discreditable act.

Professional Codes and Acts Discreditable Frankel (1989) states that by establishing a code of ethics, a profession ‘‘hopes to gain the public trust and enhance [the profession’s] status.’’ He observes that not all rules in a professional association’s code of ethics are equal: some are designed to impress outsiders, some are honored but not necessarily obeyed, while others serve as guides and some are seriously intended. Gaumnitz and Lere (2002) look at codes from professional business organizations, including accounting. Ten of the 15 codes they examine mention discreditable or harmful acts. They ﬁnd that ‘‘most’’ of the other statements in codes ‘‘y identify y appropriate or inappropriate behavior,’’ and note that the acts that may be deemed discreditable are often vague. They posit that this may be to enable the use of these sections in ‘‘enforcement proceedings,’’ and allow them to be used ‘‘ex post (as) justiﬁcation for disciplining a member.’’ They conclude that this vagueness then allows ‘‘sanctions against or expulsion of a member for nonconformity with unspecified group values or standards’’ (Gaumnitz & Lere, 2002, p. 45, emphasis added).

AICPA Code of Professional Conduct In order to understand the possible confusion over what constitutes a discreditable act for a CPA, one must ﬁrst look at the AICPA Professional Standards: Code of Professional Conduct and Bylaws (the Code) which governs CPAs. These standards consist of six Principles of Professional Conduct followed by 11 Rules. The Principles include (1) Responsibilities, (2) The Public Interest, (3) Integrity, (4) Objectivity and Independence,

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(5) Due Care, and (6) Scope and Nature of Services. Regarding Responsibilities, the relevant portion of the Code states: In carrying out their responsibilities as professionals, member should exercise sensitive professional and moral judgments in all their activities. (ET Section 52, Article I: 4291)

Under Rules, Section 500 (Other Responsibilities and Practices), Section 501, adopted January 12, 1988, addresses Acts Discreditable. Rule 501 states simply: A member shall not commit an act discreditable to the profession.

There are seven interpretations listed under Rule 501 that serve to operationalize ‘‘acts discreditable’’: 1. Retention of client records; 2. Discrimination and harassment in employment practices; 3. Failure to follow standards and/or procedures or other requirements in governmental audits; 4. Negligence in the preparation of ﬁnancial statements; 5. Failure to follow requirements of governmental bodies, commissions, or other regulatory agencies; 6. Solicitation or disclosure of CPA examination questions and answers; and 7. Failure to ﬁle tax return or pay tax liability. There is a potential lack of clarity among these speciﬁc provisions in that the Code uses the verb ‘‘is’’ for offenses 1, 3, and 5 (i.e., each ‘‘is’’ an act discreditable); offense number 2 says it ‘‘will be presumed to be;’’ numbers 4 and 6 ‘‘shall be considered to be;’’ and 7 says it ‘‘may be considered’’ to be.1 A few studies have examined the AICPA’s enforcement of the acts discreditable provision, which may provide additional guidance into what the AICPA considers to be actionable violates of Rule 501. For example, Tidrick (1992) examined AICPA joint trial board actions from 1980 to 1990 and found that 28 of the 117 trial board actions (i.e., 23.9%) involved a violation of Rule 501 on acts discreditable. He also examined automatic expulsions from the AICPA, and found that 16.3% of expulsions were for ‘‘failing to ﬁle returns or y preparing fraudulent tax returns,’’ the ﬁrst of which is an act discreditable as deﬁned by Rule 501. More recently, Moriarity (2000) examined sanctions (including those for acts discreditable and for other member violations) by the AICPA from 1979 through 1999, and summarized the type of acts for which members have received sanctions. The top category of sanctioned acts was tax issues (including

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failure to ﬁle a personal return, which is an ‘‘act discreditable’’ as deﬁned by the Code). He also found that 11 of 304 sanctions for ‘‘substandard professional service’’ were ‘‘failure to return client records,’’ which is one of the acts speciﬁcally proscribed by the AICPA Code as an act discreditable.

Literature on Acts Discreditable Stanley (2004) discusses the nature of acts discreditable in the Texas context. He indicates that the discreditable acts extend beyond acts committed within the conﬁnes of being a CPA. He further contends ‘‘No other ethics rule is as misunderstood as the discreditable acts rule.’’ He goes on to state that the ‘‘lack of speciﬁcity in the rule is deliberate.’’ McGee (1998a, 1998b, 1998c, 1999) believes that accounting organizations should not ‘‘engage in policing the moral conduct of their members unless [such conduct] adversely affects a client or segment of the investing public.’’ McGee’s series of articles probes what types of behavior might be considered ‘‘discreditable to the profession’’ if a broader understanding of the term is used. He suggests that assuming an act can do harm to a collective term like ‘‘the profession’’ could lead to almost any act that may offend someone being deemed discreditable. McGee also calls for the repeal of Rule 501, based on the difﬁculty of monitoring these provisions and the rule’s vagueness.

The Role of the States in Defining ‘‘Acts Discreditable’’ CPAs are licensed by individual states. These various states have different regulatory climates and approaches to oversight of the accounting profession. For example, Gantt, Generas, and Lamberton (2006) posit that states affected by recent scandals might be the most likely to narrow down the states’ regulations of the accounting profession. They look at the responses of Arizona, Connecticut, Texas, California, and New York to recent scandals and conclude that of the ﬁve, only California had tightened up its overall regulations. The AICPA Code applies to those CPAs who choose to join the AICPA, and is often used by the state board of accountancy in interpreting the state’s professional rules. States, however, are free to develop their own rules of conduct. States that have adopted their own rules typically are more strict than the AICPA Code. The state adoption of local codes of conduct has

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Code of Conduct or other regulation New York (Same as AICPA Code)

Acting as CPA Yes

California (Sections 5063 (a) and (b))

Yes

Texas (Section 501.90)

Yes

Fig. 1.

In business-related capacity Limited (e.g., failure to file personal tax return)

In CPA’s personal life Silent (presumably not considered discreditable)

Yes (e.g., misappropriation; breach of fiduciary responsibility) Yes

Silent (presumably not considered discreditable) Yes (e.g., any felony; criminal prosecution for moral turpitude or alcohol abuse)

‘‘Acts Discreditable’’ Provisions of Selected States What Types of Act Discreditable?

resulted in differences among states with regard to the scope of activities that may be considered discreditable. Fig. 1 presents a summary of state ‘‘acts discreditable’’ provisions for the states with the largest number of CPAs. The provisions are divided into acts that relate to the CPA’s core client-service functions (labeled ‘‘Acting as CPA’’), actions taken by CPAs in a business or ﬁnancial context (labeled ‘‘In business-related capacity’’), and actions unrelated to business/ﬁnancial context (labeled ‘‘In CPA’s personal life’’). Note that the states (and the AICPA) agree that inappropriate acts committed in the CPA’s client-service capacity (e.g., signing-off on misleading ﬁnancial statements) are considered discreditable. States vary about the speciﬁc types of inappropriate acts related to business or ﬁnance that may be discreditable, with California and Texas having fairly broad language, while New York (and the AICPA Code) provide only limited examples. With regard to whether acts of CPAs in their personal lives may be discreditable, two of the three states are silent on this issue. Texas, however, broadens the deﬁnition of acts discreditable to incorporate acts of ‘‘moral turpitude’’ and alcohol abuse. This broad deﬁnition prompted Stanley (2004) to note that the state of Texas has some items in their list that ‘‘almost appear comical.’’ Given the divergent views of different states, and the vagueness of many of the professional code provisions regarding ‘‘acts discreditable,’’ we seek to examine whether there is any consensus among CPAs about what types of acts may be discreditable, and whether they view inappropriate acts outside

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of their CPA role to be discreditable. These are the ﬁrst two research questions of our study, stated as follows: RQ1. Is there a consensus among CPAs about what kinds of acts may discredit the profession? RQ2. Do CPAs view acts outside of their client-service role to be discreditable?

The Potential Roles of Moral Intensity Jones (1991) develops an ‘‘issue-contingent’’ model of ethical decision making. He indicates that an individual’s response to an ethical issue would differ depending on the moral intensity of the issue. Moral intensity consists of magnitude of consequences, social consensus, probability of effect, temporal immediacy, proximity of effect, and concentration of effect. With regard to social consensus, Ferrell and Gresham (1985) note that consensus regarding proper ethical conduct will be likely to change as the issue changes. They suggest that fewer people would endorse embezzling company funds than would endorse padding an expense account. Packer (1968) says one of the functions of penalties in criminal law is retribution and that the extent of retribution is often proportional to the evil perpetrated. This argument is framed as a reﬂection of the moral intensity of the act. Laczniak and Inderrieden (1987) ﬁnd that subjects in an ethical judgment experiment rejected illegal decisions more often than unethical (but not illegal) decisions. They conclude ‘‘in order for individuals to respond appropriately to a given situation, agreement must exist as to whether or not the behavior is appropriate.’’ These arguments lead Jones (1991) to conclude that social consensus implied by legal prohibition reduces moral ambiguity. In the context of this study, the speciﬁc prohibition of an act in the AICPA Code may lead to a perception that social consensus exists that the act is discreditable. This may lead CPAs to be more likely to view these acts as discreditable. This is the third research question of our study: RQ3. Are acts speciﬁcally prohibited by the AICPA Code of Conduct more likely to be considered discreditable than other acts? The remaining aspects of Jones’ moral intensity (e.g., magnitude of consequences, probability of effect, temporal immediacy, proximity of effect, and concentration of effect) may also affect CPAs’ perceptions

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of whether an act is discreditable. These aspects of moral intensity focus on the effects of the act. CPAs may be more likely to view acts that have signiﬁcant consequences to be discreditable. This is the fourth research question of our study: RQ4. Are acts with more serious effects (i.e., acts of greater moral intensity) more likely to be considered discreditable than other acts?

The Potential Role of CPA Characteristics Research has shown that subjects’ responses to ethical situations may vary based on their demographic proﬁle. For example, Cohen, Pant, and Sharp (1998) found that female respondents’ reactions to ethical vignettes differed from male respondents. CPAs of different ages may also have different ideas of what constitutes a discreditable act given the differing standards that may have prevailed in their formative years. Respondents from public accounting may also differ in their views of what types of actions are discreditable relative to CPAs in business and industry. These are the ﬁnal research questions of our study, and are stated as follows: RQ5. Do males and females have different perceptions of what acts are discreditable? RQ6. Do perceptions of whether acts are discreditable differ based on the respondent’s age? RQ7. Are CPAs in public accounting more likely to consider acts to be discreditable than their colleagues working in business and industry?

RESEARCH METHODS Development of Scenarios To examine whether CPAs view certain acts to be discreditable to the profession, we developed a number of short scenarios representing actions that a CPA might take. The acts fell into three categories: (1) acts committed by CPAs performing client services; (2) acts committed by CPAs unrelated to their client-service activities, but which have direct business or ﬁnancial

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implications; and (3) acts committed by CPAs in their personal life with no direct link to business. Independently of the above three categories, we also included acts that the AICPA Code of Professional Conduct speciﬁcally prohibits (such as withholding client documents in a fee dispute), in addition to items that are not speciﬁcally mentioned in the AICPA Code. We also attempted to vary the actions in terms of their potential moral intensity (Jones, 1991) such that some of the acts had more serious societal consequences than others. The scenarios were developed based on acts or ideas discussed in the AICPA Code, previous articles discussing acts discreditable (e.g., McGee, 1998a, 1998b, 1998c; Stanley, 2004), and a number of state codes of CPA conduct. To examine the potential sensitivity of the responses to the gender of the CPA engaging in the potentially discreditable act, we also varied the gender of the CPA involved in 13 of the 15 scenarios on one-half of the surveys.2 After review by academic and practitioner colleagues, the scenarios were modiﬁed to ensure clarity and consistency. Certain scenarios were also reviewed by experts in a particular ﬁeld to ensure clarity of the issue (e.g., the scenario on gender discrimination was reviewed by a University’s Vice President for Human Resources (HR), and a faculty member specializing in HR). The full text of the scenarios is presented in the appendix.

Measurement of CPAs’ Perceptions For each scenario, respondents were asked the following questions: a. ‘‘Do you think the act is discreditable?’’ Responses were ‘‘yes’’ or ‘‘no.’’ b. ‘‘How conﬁdent are you in your assessment that the act is or is not discreditable?’’ Responses were on a 5-point scale from 1 ¼ ‘‘very uncertain’’ to 5 ¼ ‘‘very conﬁdent.’’ Note that in both the cover letter and the instructions on the survey instrument, we speciﬁcally stated that we wanted the subject’s opinion as to whether the act was discreditable. We were not endeavoring to assess subjects’ knowledge of the AICPA or any other state code of conduct, or whether they felt that the action would result in a sanction under existing codes. We also clearly stated to the respondents that there were no right or wrong answers, but only their opinions. After responding to the 15 scenarios, respondents were presented with the following statement: ‘‘Negative actions taken by CPAs outside of their public accountant role (e.g., in their personal lives) can discredit the

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profession.’’ Respondents were asked to express their level of agreement with this statement on a 7-point Likert scale from 1=strongly disagree to 7=strongly agree. Respondents also provided demographic information.

Respondents To obtain a sample of CPAs to complete the survey, the AICPA3 provided the researchers with a listing of 1,500 names and addresses of its members. As per the researchers’ request, these 1,500 CPAs included the following: a. 500 CPAs engaged in public accounting practice, b. 500 CPAs working in business and industry, and c. 500 additional CPAs (from either practice or industry) selected from the ﬁve states with the largest number of AICPA members. These states were California, New York, Texas, Florida, and Illinois.4 This last portion of the sample was designed to facilitate potential state-based comparisons. Survey instruments were mailed to the 1,500 potential respondents. Included in each package were a cover letter from the researchers, a copy of the research instrument, and postage-paid return envelope. Fifty-two of the envelopes mailed were returned as undeliverable, yielding a potential respondent pool of 1,448 CPAs. Responses were obtained from 275 participants, resulting in a response rate of 19%. Because some respondents did not fully complete the research instrument, usable responses vary from 236 to 274, depending on the particular issue addressed. Summary statistics on the respondents are shown in Table 1. As shown in Table 1, the majority of our respondents (57.9%) are from 40 to 49 years old, and 79.6% are male. The percentage currently working in public accounting is 60.4%, and the average respondent has 16.8 years of public accounting work experience. Examining Panel B, the average respondent working in public accounting is a partner (74.3% of public accounting respondents), and is employed in a single ofﬁce regional ﬁrm (50.9%) or as a sole practitioner (30.9%). Among those respondents employed in business and industry, the majority of respondents were either internal auditors (41.3% of business and industry respondents) or ﬁnancial/accounting management (26.6%). The majority (53.2%) of these respondents from business and industry work in ﬁrms with 500 or fewer employees (24.6% from ‘‘100 to 500 employees’’ and 28.6% from ‘‘less than 100 employees’’). In sum, our respondents appear to represent fairly experienced CPA accounting professionals.

Age

Demographic Proﬁle of Respondents. Number of Respondents

% of Respondents

3 6 158 106 207 53 165 108

1.1 2.2 57.9 38.8 79.6 20.4 60.4 39.6

20–29 30–39 40–49 50 and above Male Female Public accounting Business & industry

Gender Currently working in

Years of experience at current ﬁrm Years of experience in public accounting Respondents in Public Accounting

Position

Staff Senior Manager Partner

Firm size

Big 4 ﬁrm Large national ﬁrm (other than big 4) Large regional ﬁrm (multiple ofﬁces) Regional ﬁrm (single ofﬁce) Sole practitioner

Mean

SD

13.6 16.8

8.5 10.1 Respondents in Business and Industry

Number

Percentage

3 8 24 101

2.2 5.9 17.6 74.3

9 4 17 84 51

5.5 2.4 10.3 50.9 30.9

Percentage

Staff – non-ﬁnancial Internal auditor Financial/accounting staff Financial/accounting management Ofﬁcer – non-ﬁnancial CFO President/CEO/COO

12 45 6 29 7 8 2

11.0 41.3 5.5 26.6 6.5 7.3 1.8

Over 25,000 employees 10,000–25,000 employees 5,000–10,000 employees 2,500–5,000 employees 1,000–2,500 employees 500–1,000 employees 100–500 employees Less than 100 employees

18 7 8 8 10 8 31 36

14.3 5.6 6.3 6.3 8.0 6.3 24.6 28.6

57

Number

What Constitutes an Act Discreditable? An Exploratory Study

Table 1.

58

Table 1. (Continued ) Large State Responses Surveys sent

CA FL IL NY TX Total

200 97 123 108 250 778b

a b

Number sent less those returned undeliverable. Number exceeds requested 500 due to inclusion in general request.

Responses

Percent

35 23 18 15 43 134

17.5 23.7 7.8 13.8 17.2 17.2

CHARLIE CULLINAN AND KATHLEEN SIMONS

State

a

What Constitutes an Act Discreditable? An Exploratory Study

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Testing Techniques To examine whether there are differences in perceptions about whether the acts are discreditable (RQ1, RQ2, and RQ3), we computed the average percentage of respondents who responded ‘‘yes’’ to the question of whether the act was discreditable. We then computed scores for each scenario that measured whether the respondents were conﬁdent that an act was discreditable or not discreditable, or were uncertain. Speciﬁcally, we developed a 9-point scale ranging from 4 (for those respondents who did not think the act was discreditable and were very conﬁdent in their response) to +4 (for those respondents who indicated that the act was discreditable and were very conﬁdent of their response). The zero midpoint represents those respondents who were very uncertain of their response to the question of whether the act was discreditable.5 The individual scenario results on this 9-point discreditable scale were utilized in a factor analysis to determine if the subjects’ responses followed a particular pattern. To examine RQ4, and to provide further context to RQ1 and RQ2, we computed factor scores from the factor structure for each factor by respondent. To examine RQ5, RQ6, and RQ7, and to determine whether respondent characteristics (such as gender) affected the respondents’ perceptions of whether the acts were discreditable, we used ordinary least squares regression analysis with the factor responses as the dependent variable, and the following independent variables: (1) gender, (2) the respondent’s age, (3) whether the respondent works in public accounting or in business and industry, and (4) the response to the general question of whether acts of CPAs acting outside their CPA role may be discreditable.

RESULTS Respondents’ Perceptions of Whether Acts Are Discreditable or Not Table 2 presents the percentage of respondents indicating ‘‘Yes’’ to the question of whether the act is discreditable to the profession.6 The table is sorted in descending order by the percentage who felt the act was discreditable.7 The table also presents the researchers’ a priori classiﬁcations of the acts into the following categories: CPAs acting as CPAs in client service (labeled ‘‘CPA’’) CPAs acting in a business or ﬁnancial situation (labeled ‘‘Related’’) CPAs engaged in their personal life (labeled ‘‘Personal’’)

60

Table 2. Rank

Scenario

Trustee misappropriating funds Advertising tax services, misstating client’s capital gain Signing off on ﬁnancials for bigger fee Insufﬁcient audit testing due to fee constraints Withholding client documents in fee dispute (501) Not reporting problem during compilation Failing to ﬁle personal tax return (501) Downloading child pornography Giving church money to homeless man Overstating deduction on personal tax return Manslaughter under the inﬂuence Gender discrimination (501) Extramarital affair Lying about salary on internet dating site Speeding 5 miles over limit

Survey Order

Apriori Classiﬁcation

Overall

Male

Female

Male v. Female Difference

3 12 4 9 1 13 15 14 2 6 11 10 5 8 7

CPA CPA CPA CPA CPA CPA Related Personal Related Related Personal Related Personal Personal Personal

.996 .996 .985 .864 .861 .789 .773 .720 .677 .615 .603 .298 .125 .073 .011

.995 .995 .985 .854 .860 .827 .807 .692 .662 .612 .572 .269 .111 .063 .005

1 1 1 .906 .925 .934 .717 .811 .808 .660 .660 .415 .170 .076 .038

n.s. n.s. n.s. n.s. n.s. n.s. n.s. * ** n.s. n.s. ** n.s. n.s. n.s.

* Male–female difference signiﬁcantly different at pWt ¼ 0.10 or less. ** Male–female difference signiﬁcantly different at pWt ¼ 0.05 or less. n.s. ¼ Male–female difference not signiﬁcant. 501 ¼ Speciﬁcally prohibited by AICPA rule 501. CPA ¼ CPA acting as CPA in providing services. Related ¼ CPA not acting CPA, but engaging in business or ﬁnancial activities. Personal ¼ CPAs engaged in their personal lives.

CHARLIE CULLINAN AND KATHLEEN SIMONS

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

Respondents’ Perceptions of Acts.

What Constitutes an Act Discreditable? An Exploratory Study

61

The overall percentages viewing the acts as discreditable ranged form 99.6% (for misappropriating funds and misstating client’s tax return) to 1.1% (speeding 5 miles over the speed limit). The six acts that the largest number of CPAs viewed as being discreditable all represented acts of CPAs acting in a client-service capacity. This result suggests that, with regard to RQ1, there is a reasonable degree of agreement among CPAs that inappropriate acts committed in a CPA’s client-service capacity do discredit the profession. Acts of CPAs related to business and ﬁnance and acts by CPAs in their personal lives were generally less likely to be viewed as ‘‘discreditable’’ than acts of CPAs in their client-service role. There was no clearly discernable distinction in Table 2 between ‘‘related’’ acts and ‘‘personal life’’ acts in terms of the percentage of respondents who viewed the acts as being discreditable. These results suggest a mixed response to RQ2 that some acts outside the CPA’s client-service role discredit the profession, while others do not. With regard to acts that the AICPA Code speciﬁcally indicates to be discreditable (i.e., withholding client ﬁles, failing to ﬁle personal tax return, and gender discrimination), Table 2 shows that there is no agreement among respondents that these acts discredit the profession. This result may indicate that the respondents do not agree with the speciﬁc provisions of the AICPA Code. Based on these results, the answer to RQ3, regarding acts speciﬁcally prohibited by the Code is that these acts are not more likely to be considered discreditable than other acts. The results were inconclusive regarding acts with higher moral intensity (i.e., manslaughter under the inﬂuence and child pornography) as investigated in RQ4. While these acts were more likely than some other non-CPA acts to be considered discreditable, they were not among the highest rankings. Also presented in Table 2 are the percentages of male and female respondents who viewed the act as being discreditable. For most of the acts, there was no signiﬁcant difference between the male and female respondents. The only signiﬁcant differences were in the scenarios involving child pornography, giving church money to a homeless man, and gender discrimination. For each of these acts, the female respondents were more likely to consider the act to be discreditable. These results provide some support for RQ5, by ﬁnding that, in some instances, males and females did view the acts differently.

Factor Analysis The results of factor analysis applied to the 9-point scale ranging from 4 (very conﬁdent that the act is not discreditable) to +4 (very conﬁdent that

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the act is discreditable) are presented in Table 3. The analysis yielded four factors. The factor results suggest that subjects viewed the scenarios as relating to four distinct areas, and the factor structure appears to be relatively clean with no scenario loading on more than one factor. We endeavored to determine commonalities among the scenarios that loaded onto each of the factors. The ex-post descriptions of these commonalities are presented with factor number in the table. With regard to the distinction between CPAs in client service, and CPAs engaged in a business or ﬁnance issue, there appear to be two factors related to these ideas in Factors 1 and 2. The factor loadings appear to fall cleanly into these two areas with the exception of ‘‘not reporting problems to management during a compilation,’’ which empirically loads on Factor 1, while the a-priori theoretical classiﬁcation would suggest that the scenario would be a better ﬁt with Factor 2. The scenarios representing actions taken by CPAs in their personal lives load on two factors (Factors 3 and 4). The main difference in the scenarios appears to be the level of moral intensity. In Factor 4, the acts are both illegal (reﬂecting ‘‘social consensus’’) and have relatively high consequences. In Factor 3, while the acts may represent personal ethical lapses, the consequences are less severe than the issues in Factor 4. Also, in Factor 3, only one of the three acts (speeding) is illegal, and the consequences of exceeding the speed limit by 5 miles/hour are rather limited. We therefore considered these factors to represent acts in the CPA’s personal life, with Factor 3 representing personal-life issues of lower moral intensity, and Factor 4 representing personal-life issues of higher moral intensity. Also in Table 3, we present the mean response on the 4 to +4 ‘‘discreditable’’ scale, where a positive number indicates that the mean respondent was conﬁdent that the act was discreditable, and a negative number indicating that the average respondent was conﬁdent that the act was not discreditable. For Factor 1, there is some variation among the scenarios in whether the respondents considered the act to be discreditable, with responses ranging from 1.21 to +1.88. In Factor 2, all the scenarios were viewed as being discreditable, with mean responses ranging from 2.46 to 3.70. Scenarios in Factor 3 were all viewed (on average) as not being discreditable, with mean responses from 2.67 to 3.65. Finally, the scenarios in Factor 4, while being viewed as discreditable (on average) were not strongly viewed as discrediting the profession. Table 4 presents descriptive statistics on each of the factors.8 As with the percentages of respondents considering the acts to be discreditable (Table 2), the results presented in Table 4 indicate that most CPAs consider acts committed while in the CPA role (Factor 2) to be discreditable, and that most

Factor Structure, Promax Rotation Variables 4 ¼ Very Conﬁdent Act is Not Discreditable, 0 ¼ Very Uncertain, 4 ¼ Very Conﬁdent Act is Discreditable.

Scenario

Sequence

Mean Response

Factor 1

Factor 1: Not acting as CPA in business/ﬁnancial situations Failing to ﬁle personal tax return Overstating deduction on personal tax return Not reporting problem to management during compilation Gender discrimination Giving church money to homeless man

15 6 13 10 2

1.88 0.77 1.85 1.21 1.24

0.78 0.63 0.58 0.48 0.44

Factor 2: Acting as CPA in providing client-services Trustee misappropriating funds Withholding client documents in fee dispute Signing off on ﬁnancials for bigger fee Advertising tax services, misstating client’s capital gain Insufﬁcient audit testing due to fee constraints

3 1 4 12 9

3.66 2.50 3.63 3.70 2.46

Factor 3: CPA’s personal life; issues of lower moral intensity Speeding 5 miles over limit Lying about salary on internet dating site Extramarital affair

7 8 5

3.65 2.94 2.67

Factor 4: CPA’s personal life; issues of higher moral intensity Downloading child pornography Manslaughter under the inﬂuence

14 11

1.68 0.82

Factor 2

Factor 3

Factor 4

0.73 0.67 0.62 0.49 0.46 0.76 0.70 0.52

What Constitutes an Act Discreditable? An Exploratory Study

Table 3.

0.88 0.86

Italics ¼ Not strong theoretical ﬁt.

63

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CHARLIE CULLINAN AND KATHLEEN SIMONS

Table 4. Factor #

2 4 1 3

Descriptive Statistics on Factors.

Ex-post Classiﬁcation

CPA acting as CPA in providing clientservices CPA’s personal life; issues of high moral intensity Not acting as a CPA in business/ﬁnancial situation CPA’s personal life; issues of lower moral intensity

Mean (SD) % Who think act is discreditable

4 to +4 Scale

94.0 (0.11) 66.1 (0.42) 63.0 (0.27) 6.9 (0.18)

3.20 (0.92) 1.24 (2.64) 0.89 (1.71) 3.09 (1.29)

4 ¼ Very conﬁdent that act is not discreditable. 0 ¼ Very uncertain. +4 ¼ Very conﬁdent that act is discreditable.

CPAs consider inappropriate acts of low moral intensity committed in a CPA’s personal life (Factor 3) not to be discreditable. There are also relatively small standard deviations on the responses to each of these factors, suggesting that there is agreement among the respondents on these issues. For acts involving the CPA’s personal life that are of higher moral intensity (Factor 4), and acts committed by CPAs in business and ﬁnance situations, the ‘‘discreditable’’ responses for both of these factors were in the 60% range. The relatively large standard deviations on these two factors indicate that there was no broad agreement among the respondents as to whether or not these acts may discredit the profession. These ﬁndings provide further evidence on RQ1 and RQ2 suggesting that CPAs generally agree that inappropriate acts committed in a CPA’s clientservice role do discredit the profession. Those acts outside of the client-service role may or may not discredit the profession depending on whether the act is related to business or ﬁnance. RQ4 is also addressed by these ﬁndings, which indicate that acts with more serious effects (i e., greater moral intensity) are more likey to be seen as discreditable than acts of lower moral intensity.

Regression Analysis Results of regressing the factor scores (on the 9-point scale from 4 to +4) on certain demographic variables of interest are presented in Table 5.9,10

What Constitutes an Act Discreditable? An Exploratory Study

Table 5.

65

OLS Regression Results.

Mean factor scores, 4 to +4 scale Parameter estimate t Value (pWt, two-tail) Dependent Variable

Intercept

Gender

Age

Work in public accounting?

General question: Are acts outside CPA role discreditable? Model F pWF Adjusted R2 Sample size

Factor 1

Factor 2

CPA in business/ ﬁnance

CPA acting as CPA

0.53 0.71 (0.481) 0.05 0.21 (0.832) 0.22 1.18 (0.241) 0.39 1.83 (0.069) 0.26 4.33 (0.0001) 5.53 0.003 0.072 236

3.10 7.47 (0.0001) 0.06 0.42 (0.672) 0.05 0.49 (0.626) 0.00 0.00 (0.998) 0.04 1.34 (0.181) 0.53 0.711 0.008 244

Factor 3

Factor 4

Personal life: Personal life: low intensity high intensity

3.49 6.24 (0.0001) 0.28 1.54 (0.148) 0.17 1.24 (0.215) 0.03 0.16 (0.870) 0.13 2.95 (0.004) 3.05 0.018 0.032 247

1.55 1.54 (0.126) 0.74 2.12 (0.035) 0.48 1.94 (0.054) 0.04 0.15 (0.883) 0.72 9.21 (0.0001) 23.03 0.0001 0.261 250

These results provide evidence with regard to RQ5, RQ6, and RQ7. In each of these models, with the exception of Factor 2, the subject’s response to the statement: ‘‘Negative action taken by CPAs outside of their public accountant role (e.g., in their personal lives) can discredit the profession’’ was signiﬁcant. This ﬁnding suggests that respondents viewed the scenarios included in Factors 1, 3, and 4 as reﬂecting CPA’s actions outside of their public accounting role, while they viewed the acts included in Factor 2 as representing the public accounting role. For Factor 2, neither the overall model nor any of the individual variables is signiﬁcant. This result most likely arises from the small standard deviation

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CHARLIE CULLINAN AND KATHLEEN SIMONS

in this variable, reﬂective of the strong agreement among respondents that these acts, committed by CPAs in their client-service role, are discreditable. Factor 3, while resulting in a signiﬁcant model overall, has low explanatory power, which also reﬂects the relatively low level of variation in the respondents’ perceptions of these acts. Speciﬁcally, there is general agreement among the respondents that these personal-life, low moral intensity issues are not discreditable. For Factor 1, the overall model is signiﬁcant, and an analysis of the independent variables indicates that those working in public accounting were marginally less likely to be conﬁdent that the acts were discreditable than CPAs in business and industry. The model with greatest explanatory power (i.e., R2) is found in the regression model in which Factor 4 is the dependent variable. This is also the factor that displayed the greatest variation (standard deviation) in the statistics presented in Table 4. These results suggest that female respondents are signiﬁcantly more likely to view these acts as being discreditable, and that older CPAs were marginally less likely to consider these acts to be discreditable.

Limitations This study is subject to a number of limitations. For example, our subject pool was limited to CPAs who are members of the AICPA. CPAs who choose not to join this national organization may view these issues differently. In addition, we chose to examine only certain acts that might be considered discreditable. We did not, for example, include all the acts speciﬁcally mentioned in the AICPA code (we chose three of the seven). There may have been greater agreement among CPAs among the speciﬁcally prohibited acts that we did not include. Finally, our survey was limited to CPAs. Further study examining the topic of what constitutes a discreditable act could involve surveying the public to see if their views coincide with those of the CPAs in this chapter. Groups that might be surveyed would include bankers, investors, tax clients, etc.

DISCUSSION AND IMPLICATIONS This study examined CPAs’ perceptions of whether certain acts committed by CPAs may discredit the profession. The results indicate that there is general agreement that inappropriate acts in a CPA’s client-service role are

What Constitutes an Act Discreditable? An Exploratory Study

67

discreditable. For acts outside of the CPA’s client-service role, CPA’s, opinions varied as to whether the acts were discreditable. We also found that there is not broad agreement among CPAs that acts speciﬁcally mentioned in the AICPA Code are discreditable. This lack of overall agreement implies that there is no consensus among CPAs on what constitutes a discreditable act. The major implications from these ﬁndings are that CPAs are either unaware of the examples given in the current Code, and/or there is an issue with the clarity and completeness of the given examples. Some degree of ambiguity in deﬁning acts discreditable may be intentional and necessary for the profession to respond to unforeseen circumstances, and to ensure that the public interest is protected. However, greater clarity may decrease the likelihood that CPAs might unintentionally violate this section, and facilitate the identiﬁcation of any breaches of the speciﬁcally prohibited acts and to determine the appropriate discipline.

FUTURE RESEARCH This study is seen as an exploratory work. Further research is envisioned which varies the types of scenarios presented in order to continue reﬁning the search for consensus. In addition, audiences other than CPAs, representing users of ﬁnancial statements and services of CPAs, could be surveyed to determine if their views coincide with those of the CPAs. Also, a suggested list of acts to add to the existing Code could be written and proposed for acceptance. Finally, as professional bodies work toward the development and convergence of professional codes, which cross international borders, an examination of these issues in different cultural contexts may be useful.

NOTES 1. See Lindblom and Ruland (1997) for a discussion of what they consider ‘‘semantic defects’’ in AICPA Code of Conduct. 2. None of the actors’ gender changes resulted in signiﬁcant differences in the responses. 3. The authors wish to acknowledge assistance by the AICPA in obtaining a sample; however, the current research has not been approved or endorsed by the AICPA. 4. Note that CPAs from these states were also included in the 500 CPAs from practice and 500 from industry.

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5. Results using an alternative 10-point scale, in which subjects responding ‘‘yes’’ or ‘‘no’’ but indicating that they were very uncertain were split into two groups in the middle of the scale, were not materially different from results using the 9-point scale. 6. An analysis of early and later respondents revealed no signiﬁcant difference on these variables, suggesting that non-response bias was not a material concern. 7. The ‘‘Survey Order’’ column indicates the order in which the scenarios appeared on the research instrument. Given the random pattern, there do not appear to be order effects that may have affected the subject’s responses. 8. Combined factor scores were computed by averaging the scores by respondent for the scenarios in each of the factors. These scores were then averaged across respondents to obtain the information shown in Table 4. 9. When using the ‘‘yes’’ or ‘‘no’’ response as the dependent variable, results were not materially different. 10. In unreported analyses, we also included dummy variables representing whether the respondents were from any of the states with the largest numbers of CPAs (i.e., California, Florida, Illinois, New York, and Texas). With the exception of the Texas dummy variable being signiﬁcant for the Factor 4 model, none of the state variables were signiﬁcant at conventional levels in any of the models.

ACKNOWLEDGMENTS The authors gratefully acknowledge the helpful assistance of Cyndie Jeffries, editor; the anonymous reviewers; and the participants at the 2006 AAA Ethics Symposium.

REFERENCES American Institute of Certiﬁed Public Accountants (AICPA). (2006). AICPA professional standards: Code of professional conduct and bylaws. New York: AICPA. Cohen, J. R., Pant, L. W., & Sharp, D. J. (1998). The effects of gender and academic discipline diversity on the ethical evaluations, ethical intentions and ethical orientation of potential public accounting recruits. Accounting Horizons, 12, 250–270. Ferrell, O. C., & Gresham, L. G. (1985). A contingency framework for understanding ethical decision making in marketing. Journal of Marketing, 49, 87–96. Frankel, M. S. (1989). Professional codes: Why, how, and with what impact. Journal of Business Ethics, 8, 109–115. Gantt, K., Generas, G., & Lamberton, B. (2006). Sarbanes–Oxley, accounting scandals and atate accountancy boards. Presented at the Northeast American Accounting Association Meeting, April. Portsmouth, NH, USA. Gaumnitz, B. R., & Lere, J. C. (2002). Contents of codes of ethics of professional business organizations in the United States. Journal of Business Ethics, 35, 39–49. Jones, T. M. (1991). Ethical decision making by individuals in organizations: An issuecontingent model. The Academy of Management Review, 16, 366–395.

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Laczniak, G. R., & Inderrieden, E. J. (1987). The inﬂuence of stated organizational concern upon ethical decision making. Journal of Business Ethics, 6, 297–307. Lindblom, C. K., & Ruland, R. G. (1997). Functionalist and conﬂict views of AICPA Code of Conduct: Public interest v. self interest. Journal of Business Ethics, 16, 573–582. McGee, R. W. (1998a). Does adoption of an afﬁrmative action policy constitute an act discreditable to the profession? A philosophical look at a practical ethical question. Journal of Accounting, Ethics and Public Policy, 1, 275–278. McGee, R. W. (1998b). Does providing minority scholarships constitute an act discreditable to the profession? A philosophical look at a practical ethical question. Journal of Accounting, Ethics and Public Policy, 1, 349–355. McGee, R. W. (1998c). Should private discrimination constitute an act discreditable to the profession? A philosophical look at a practical ethical question. Journal of Accounting, Ethics and Public Policy, 1, 681–687. McGee, R. W. (1999). What constitutes an act discreditable to the profession? A philosophical look at a practical ethical question. Journal of Accounting, Ethics and Public Policy, 2, 97–103. Moriarity, S. (2000). Trends in ethical sanctions within the accounting profession. Accounting Horizons, 14, 427–439. Packer, H. L. (1968). The limits of the criminal sanction. Stanford, CA: Stanford University Press. Stanley, C. (2004). Acts discreditable. Today’s CPA, 28–32. Tidrick, D. E. (1992). Disciplinary actions by the AICPA against individual members, 1980 to 1990. Research in Accounting Regulation, 6, 163–177.

APPENDIX. POTENTIALLY DISCREDITABLE ACT SCENARIOS Scenario 1: Kristen McPhail, CPA, is involved in a fee dispute with a former client. To pressure the client to pay the disputed fees, McPhail has withheld client-provided documents that the client needs to prepare their tax return. Scenario 2: Andrew Morehouse, CPA, the volunteer treasurer for his local church, gave church money to a local homeless man without an approval from (or even informing) the church council. Scenario 3: Christine Whaler, CPA, misappropriated funds from an account of which she was a trustee. Scenario 4: Corrine van der Veen, CPA, found a material misstatement in her client’s ﬁnancial statements. When the client offered to triple the audit fee, Corrine signed off on the ﬁnancial statements that contained the misstatement. Scenario 5: Patrick Gober, CPA, had an extramarital affair.

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Scenario 6: Regina Cosgrove, CPA, donated her old car to a local charity. When preparing her tax return, she overstated the value of the car donation. Scenario 7: John Malin, CPA, was ticketed for driving his car at 60 miles/h in an area where the speed limit is 55 miles/h. Scenario 8: Vanessa Appleby, CPA, (who is single) slightly exaggerated her annual salary in a survey she completed for an Internet dating site. Scenario 9: Christopher Swenson, CPA, audited the pension plan of a local union, which paid him $1,000 for the audit. Later, when a peer reviewer indicated that Swenson had not done sufﬁcient testing, Swenson indicated that he performed $1,000 worth of testing, because that is all the client paid for. Scenario 10: Due to declining business, Tom Allen, CPA, was forced to lay off one of his audit staff members. He chose to lay off a female staff member, rather than a male staff member, because he felt that the female staff member’s ‘‘husband can take care of her.’’ Scenario 11: Driving home from her ofﬁce Christmas party, Robert Riccio, CPA killed a pedestrian that he struck with his car. He was found guilty of manslaughter, and driving under the inﬂuence of alcohol. Scenario 12: Samuel Wonner, CPA, advertised that he guaranteed a larger tax refund for his clients ‘‘than anyone else in town.’’ He typically achieved this larger refund by overstating the cost basis of stocks sold by his clients. Scenario 13: During a compilation engagement, Regina Sands, CPA, noticed that the client did not depreciate assets. Because the compilation report provides no assurance, Regina did not bring the depreciation issue to the client’s attention. Scenario 14: Charles Smith, CPA, has been convicted of downloading child pornography. Scenario 15: Brigette Skyler, CPA, never ﬁled her personal tax return for 2003.

CAREER AMBITION VS. CONCERN FOR OTHERS: THE RELATIONSHIP OF PERSONAL VALUES TO EGREGIOUS ACCOUNTING AND FINANCIAL DECISIONS Frank Collins, Suzanne Lowensohn and Michael K. Shaub ABSTRACT In recent years, it has become evident that ethical decision making by accountants and other individuals within business organizations is a relevant social issue. Extensive research suggests that individuals act in their own self-interest (i.e., Vroom, 1964; Jensen & Meckling, 1976, 1994); however, opportunistic economic behavior is often constrained by altruism or virtue (Jensen, 1994; Rutledge & Karim, 1999). The current study examines whether two different personal values are determinants of unethical decision making in an accounting context. Based on the fundamental ethical conflicts internal to the individual as described by Adam Smith (1976), the research model incorporates employee incentives to maximize career-related rewards (termed ‘‘Career Ambition’’) and a measure of altruism and virtue derived from the spirituality literature (termed ‘‘Concern for Others’’).

Research on Professional Responsibility and Ethics in Accounting, Volume 12, 71–99 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1574-0765/doi:10.1016/S1574-0765(07)00204-X

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Using a web-based survey and LISREL analyses, we find that individuals with higher degrees of Career Ambition are more likely to make Egregious Decisions; while alternately, individuals that express a greater Concern for Others are less likely to make these unethical decisions. In light of various corporate and regulatory efforts to improve business practices, our findings suggest that elements of Career Ambition and Concern for Others are indeed associated with unethical decision making and should be appropriately considered by organizations and governing bodies.

Accounting and ﬁnancial scandals of late have troubled the worldwide investment community, as well as the general public. In the past decade, scandalous events include the Enron collapse and the subsequent demise of the public accounting ﬁrm, Arthur Andersen, as well as fraudulent ﬁnancial and ﬁduciary activities at companies such as MCI WorldCom, Adelphi Communications, ImClone, Dynegy, and Martha Stewart Living Omnimedia (Business Week, 2002). The problems are not restricted to the United States, as demonstrated by the arrest and indictment of Calisto Tanzi and his associates in Italy for allegedly embezzling billions in the Parmalat scandal and the revelation that some of Royal Dutch Shell’s oil reserves are nonexistent (Komp, 2004). Such instances of scandal and fraudulent behavior, often associated with unethical decision making by employees, are not isolated events or new phenomena. In fact, they clearly represent a relevant societal and organizational issue.1 Thus, the present research was conducted to shed light on the personal values of individuals with tendencies to make unethical decisions. Mainstream models of human behavior in economics (Rutledge & Karim, 1999; Jensen, 1994), as well as social psychology (Petri & Govern, 2004; Kanfer, 1990; Vroom, 1964), suggest that individuals act in their own selfinterest; however, opportunistic behavior is often constrained by altruism or virtue (Jensen, 1994; Rutledge & Karim, 1999).2 In this study, we present individuals with several hypothetical scenarios to measure their likelihood to make egregious decisions. We also examine the potentially conﬂicting effects of career-related incentives and individual concern for others on their decisions. Our objective is to explore why individuals provided with the same stimuli might provide different responses. Career Ambition measures the inﬂuence of career-related rewards, while Concern for Others measures elements of virtue and altruism.3 We empirically test the relationships between these two independent variables

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and ﬁve scenarios involving Egregious Decisions (our dependent variable), which are based on current scandalous events, to provide a greater understanding of existing models of ethical decision making.

MOTIVATION FOR THE STUDY We are motivated to conduct this research because no prior studies have been conducted to examine the relationship between our variables – Career Ambition, Concern for Others, and Egregious Decisions – in the context of recent business scandals. While studies with related variables exist (Nonis & Swift, 2001; Beams, Brown, & Killough, 2003; Giacalone & Jurkiewicz, 2003; Shapeero, Koh, & Killough, 2003; Gillett & Uddin, 2005), they are not representative in terms of their samples, scenarios, or variables to relate to the present environment of ﬁnancial and accounting scandals. Our study directly focuses on the relationships among the variables and gathers data directly from individuals working in an area where a number of egregious ﬁnancial and accounting acts occur, managerial accountants. Consequently, we choose to study the propensity of managerial accountants to engage in egregious decision making to discover personal values which might be associated with such behavior. We ﬁnd a positive relationship between career ambition and egregious decisions and a negative association between concern for others and egregious decisions for individuals within the study. The following sections describe theory development, research methodology, and results. The chapter concludes with discussion of the results and suggestions for future research.

THEORY DEVELOPMENT Much accounting and business ethics research is grounded in the cognitivedevelopmental perspective (Kohlberg, 1976) and follows Rest’s (1986) fourcomponent sequential model of ethical action. Prior studies have examined the relationship of personal and contextual variables to ethical sensitivity, reasoning, intentions, and behavior (O’Fallon & Butterﬁeld, 2005; Jones, Massey, & Thorne, 2003; Loe, Ferrell, & Mansﬁeld, 2000; Louwers, Ponemon, & Radtke, 1997). Most germane to the present research are those studies examining the effects of incentives and personal value systems on ethical decision making.

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In terms of incentives, Beams et al. (2003) ﬁnd that managerial accounting students are more likely to engage in insider trading as expected wealth gain increases, while Shapeero et al. (2003) conclude that accountants who perceive higher expected rewards are more likely to underreport chargeable time. Hoffman, Couch, and Lamont (1998) ﬁnd that individuals are less likely to act in an ethical manner when their economic well-being is at stake; however, Gillett and Uddin (2005) ﬁnd that CFO intention to act unethically is not affected by compensation structure. Tang and Chiu (2003) ﬁnd that the ‘‘love of money’’ is signiﬁcantly related to unethical behavior, termed ‘‘evil’’ in their study, for a sample of workers in Hong Kong. While personal values and ideals, as well as religion, provide mixed results in studies of ethical decision making in business (O’Fallon & Butterﬁeld, 2005; Nonis & Swift, 2001), Giacalone and Jurkiewicz (2003) ﬁnd that spirituality negatively inﬂuences individual perceptions of unethical practices. Only two studies were found which examine self-interest and virtue. Glass and Wood (1996) ﬁnd both positive outcomes and altruism to be signiﬁcantly related to the likelihood for students to illegally copy software. Glover, Bumpus, Logan, and Ciesla (1997) examine achievement orientation as well as concerns for honesty, fairness, and others, but do not conﬁrm hypothesized relationships. It is surprising that few studies have examined elements of self-interest and altruism together, since moral philosophers such as Adam Smith consider this conﬂict central to ethical decision making. For example, in Smith’s The Theory of Moral Sentiments, he states: To attain to this envied situation, the candidates for fortune too frequently abandon the paths of virtue; for unhappily, the road which leads to the one and that which leads to the other, lie sometimes in very opposite directions. (Smith, 1976, p. 130)

Smith does not say that self-interest and virtue are mutually exclusive, but that they are ‘‘sometimes’’ opposed to one another. However, Smith is speciﬁc in tying virtue to a concern for others’ interests. The wise and virtuous man is at all times willing that his own private interest should be sacriﬁced to the public interest of his own particular order or society. (Smith, 1976, p. 384)

Thus, understanding the tension between self-interest and others’ interests in making ethical decisions seems an important undertaking. Extant studies largely fail to focus on both the basic concepts of individual greed/self-interest and altruism, and none have focused on the role of accountants in ﬁnancial fraud as has occurred in the current

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scandalous environment. Thus, we undertake the present study which examines both self-interest and virtue as they relate to the unethical decision making of accounting professionals in this context.

Self-Interest and Career Ambition Opportunistic self-interest is a fundamental assumption of several wellestablished theories of human behavior. Traditional agency theory characterizes individuals as self-interested wealth or utility maximizers (Jensen & Meckling, 1976). In a similar fashion, expectancy theories of motivation are based upon the fundamental hedonist contention that individuals will choose to engage in actions or behaviors that maximize positive outcomes and minimize negative effects (Vroom, 1964; Fishbein & Ajzen, 1975). Both theories have been criticized for ignoring the inﬂuence of the altruistic and moralistic characteristics of individuals (Shamir, 1990; Jensen, 1994; Rutledge & Karim, 1999). A number of empirical accounting studies provide support for expectancy models of motivation and have identiﬁed rewards which are desirable and important to accountants (e.g., Ferris, 1977; Dillard & Ferris, 1979). These studies ﬁnd that extrinsic rewards, such as higher pay, bonuses and beneﬁts, status, work-role prestige, job security, promotion potential, and long-run job opportunities, are desirable to accountants and capable of motivating their behavior.4 Drawing upon these earlier studies, Lowensohn and Collins (2001) use LISREL5 conﬁrmatory factor analysis to classify many of these outcomes as either ‘‘career’’ or ‘‘status’’ reward dimensions in their study of audit partner motivation. We construct a variable, Career Ambition, from Lowensohn and Collins’ (2001) ‘‘career’’ dimension which measures the motivational intensity that individuals associate with desirable career-related outcomes. We posit that Career Ambition affects one’s tendency to make improper ﬁnancial and accounting decisions.

Concern for Others Psychologists and philosophers have long sought to explain why people often do not act purely in their self-interest, instead taking into account the interests of others. For example, theories like Hunt and Vitell’s (1986) General Theory of Marketing Ethics hypothesize that parallel deontological

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(duty-based) processes take place alongside consequentialist calculations. These deontological processes, which may be the result of character, codes, or spirituality, may lead to ethical behavior.

Character Duties to others may arise out of an individual’s self-chosen standards. Perhaps the desire is to actualize and demonstrate virtue consistent with viewing oneself as virtuous (Aristotle, 1985). Alternatively, Jensen and Meckling (1994) have suggested that individuals may rationally derive beneﬁt and maximize their interests by taking into account others’ interests, a view that was omitted from their classic agency theory work (Jensen & Meckling, 1976). People may maximize their self-interest by attaining to the ends of wisdom or honesty as much as by attaining economic gain.

Codes Codes also act to impose duties on people that include having Concern for Others. For accountants, this would include professional ethics codes such as the Institute of Management Accountants’ (IMA) Statement of Ethical Professional Practice, which requires members to ‘‘[c]ommunicate information fairly and objectively y (and) [d]isclose all relevant information that could reasonably be expected to inﬂuence an intended user’s understanding of the reports, analyses, or recommendations.’’ In other words, they must tell the truth. In addition, the American Institute of Certiﬁed Public Accountants’ (AICPA) Code of Professional Conduct bans subordination of one’s judgment to another, an excuse often heard in fraud cases where employees lie or cover up facts because they are required to ‘‘go along with the boss.’’ The AICPA code also imposes a duty to maximize truth telling in its principles section, using the terms ‘‘honest and candid’’ (ET 54.02), ‘‘intellectually honest’’ (ET 55.01), and ‘‘candid in all their dealings with members in public practice’’ (ET 55.04) to demonstrate the profession’s commitment to transparency. This truth-telling requirement of professional codes precludes the professional accountant from avoiding responsibility for others’ interests. Beyond professional codes, legal codes attach duties to individuals and organizations, including duties related to truthful representation, such as

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the CEO/CFO certiﬁcation of the ﬁnancial statements required by the Sarbanes–Oxley Act (2002). Although laws could legitimately be seen as a form of coercion imposing duties on the citizen, social coercion exists beyond explicit rules. Organizations often pressure people into giving to causes like the United Way because it is their ‘‘duty’’ to society.

Spirituality While laws and social pressures may affect people’s likelihood of acting purely in their own self-interest, the current study focuses on personal values, including spirituality. Altruistic concern for others is an important focus of most of the world’s major religious traditions (e.g., the teachings of Jesus and Paul in the New Testament, the Jewish law, the Koran, and various Eastern religions); however, when considered in the context of business or the workplace, the concept is more clearly identiﬁed as spirituality, which is not associated with any particular religion (KoracKakabadse, Kouzmin, & Kakabadse, 2002).6,7 Wheat (1991) presents a deﬁnition of human spirituality which reﬂects altruism and is consistent with individual behavior, independent of religion: y the personal valuing, experiencing or behavioral expression of (a) a larger context or structure in which to view one’s life, (b) an awareness of and connection to life itself and other living things, and (c) a reverent compassion for the welfare of others. (Wheat, 1991, p. 89)

Wheat develops a scale for the measurement of human spirituality in his dissertation. Consistent with Levinson (1978), he links spiritual development to various stages of life. This is a similar approach to the one taken by Piaget (1932) in studying cognitive development, Kohlberg (1976) in studying moral development, and Fowler (1981) in studying faith development. Wheat sees two of Kohlberg’s primary observations – that cognitive moral development may be arrested at a conventional stage and that moral reasoning does not necessarily result in moral behavior – as informing the study of spirituality as well. Wheat (1991, pp. 99–100) noted that while others have studied cognitive, emotional, and physical development extensively, spiritual development has been largely ignored. Wheat’s intention is to ﬁll a void in the psychology literature by developing a measure of spiritual development.

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Psychologists differ on the beneﬁts of spirituality, but many would agree with Young Cashwell, and Woolington’s (1998, p. 64) recognition of the ‘‘centrality of the spiritual dimension to psychosocial adjustment’’ and of its importance to ‘‘optimum wellness’’ (Martin, 1997). Some companies have found aspects of spirituality, including community and contributing to the greater good, to be important in accomplishing their mission (Milliman, Ferguson, Trickett, & Condemi, 1999). Spirituality has been inﬂuential in corporate leadership initiatives as well, from Greenleaf’s (1977) servant-leadership approach to Stephen Covey’s (1989) focus on the importance of leaders’ inward reﬂection (Wagner-Marsh & Conley, 1999). We adopt Wheat’s deﬁnition of spirituality to measure our independent variable. We choose his construct as an independent variable because logically an individual’s state of spirituality will likely affect the likelihood of committing egregious accounting and ﬁnancial acts. As will be discussed later, we use two of Wheat’s dimensions and term this variable ‘‘Concern for Others.’’

Egregious Actions Prior researchers often use scenario techniques to examine the complex nature of ethical decision making in business settings (Loe et al., 2000). In an accounting context, Flory, Phillips, Reidenbach, and Robin (1992) use scenarios to examine ethical judgments of IMA members. Consequently, we create several decision scenarios in the present study. To provide realism, the ﬁve scenarios are written to mirror recent scandals involving Tyco International, Enron, Martha Stewart Living Omnimedia, and MCI WorldCom (see Table 3). The scenarios referred to as Evading Taxes and Self-dealing involve misappropriation of assets, while Insider Trading is a misappropriation of inside information for personal beneﬁt. The remaining scenarios, Inappropriate Capitalization and Converting Allowance, represent fraudulent ﬁnancial reporting to help the company appear more proﬁtable than it is. Our dependent variable is termed Egregious Decisions, since each of the scenarios depicts the opportunity to make an accounting or ﬁnancial decision that is either fraudulent or otherwise illegal. It consists of responses regarding the likelihood that individuals would make an egregious decision in each of these ﬁve scenarios. Next, we posit hypotheses.

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Hypotheses We state the following hypotheses (in positive form because the hypotheses are directional): H1. Career Ambition is positively related to Egregious Decisions. H2. Concern for Others is negatively related to Egregious Decisions. Career Ambition is hypothesized as positively related to Egregious Decisions, because prior theory suggests that individuals will be motivated to take actions that will provide them with career-related rewards. Alternately, virtue theory suggests that a heightened Concern for Others will be negatively related to these items, since each of the egregious decisions involves unethical decisions that will be harmful to others. An individual with a high Concern for Others would not be as likely to make these decisions. Though we do not examine actual behavior, we rely on expectancy theory which suggests that attitudes inﬂuence actual behavior (Fishbein & Ajzen, 1975). Next, we discuss research methodology, beginning with instrument development.

RESEARCH METHODOLOGY Instrument Development: A Pilot Study We develop a research survey, which includes career-related reward items measuring Career Ambition, items measuring Concern for Others, and scenarios measuring each individual’s willingness to engage in unethical decision making (i.e., Egregious Decisions). Career Ambition items are adapted from Lowensohn and Collins’s (2001) study, based on earlier career-related expectancy studies of accountants. Concern for Others items are from Wheat’s (1991) three dimensions of spirituality. The egregious decision scenarios are based on current events and intended to provide a decision context in which to examine individual decision making among alternative actions. To validate the present survey instrument a pilot study of 86 MBA students was conducted at four major universities. The pilot study conﬁrms that career-related survey items effectively measure an orthogonal dimension, and that two of Wheat’s (1991) three dimensions of spirituality – (1) an awareness of and connection to life itself and other living things, and

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(2) a reverent compassion for the welfare of others – form a single vector describing one’s Concern For Others.8,9 Both variables are signiﬁcantly related to Egregious Decisions in the hypothesized directions. Having validated the variable measurements, as well as the research model, in the pilot study, we undertake the present large-scale study. Survey items used to form the independent variables termed Career Ambition and Concern for Others appear in Tables 1 and 2. The statements in Tables 1 and 2 were measured on a ﬁve-point Likert scale (1 ¼ disagree, 5 ¼ agree). Table 1.

CA 1 CA 2

CA 3 CA 4 CA 5 CA 6

Career Ambition

Mean

S.D.

I will do whatever it takes to enhance my job security. I will do whatever it takes to enhance my reputation with my company’s executives. I will do whatever it takes to enhance my promotion potential. I will do whatever it takes to enhance my pay raises. I will do whatever it takes to enhance my pay relative to my peers. I will do whatever it takes to avoid losing my job. Composite Variable

2.26

1.11

2.21

1.08

2.18

1.13

2.09

1.08

2.01

1.16

2.22

1.20

2.16

0.86

Table 2.

CFO CFO CFO CFO CFO CFO CFO

1 2 3 4 5 6 7

Career Ambition – Descriptive Statistics (n ¼ 1,153, 1 ¼ Disagree, 5 ¼ Agree).

Concern for Others. Descriptive Statistics (n ¼ 1,153, 1 ¼ Disagree, 5 ¼ Agree). Concern for Others

Mean

S.D.

I value the relationship between all living things. It is important that we be sensitive to pain and suffering. It is important that each of us ﬁnd meaning in our lives. I feel sad when I see someone in pain. I listen closely when people tell me their problems. I share my private thoughts with someone else. I enjoy guiding young people. Composite Variable

3.92 4.11 4.59 4.27 4.07 3.36 4.20 4.08

0.93 0.79 0.66 0.76 0.78 1.21 0.83 0.51

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Also, ﬁve scenarios related to opportunities to make egregious accounting decisions form our dependent variable, Egregious Decisions (see Table 3). Respondents were asked how likely they would be to make the unethical/ egregious decisions presented in Table 3, measured on a ﬁve-point Likert scale (1 ¼ not likely at all, 5 ¼ very likely).

Method Having validated the survey instrument, we study a large group of individuals that might have the opportunity to make inappropriate accounting and ﬁnancial decisions, i.e., make egregious decisions. Consequently, 22,000 members of the IMA were sent an e-mail from the Institute asking them to participate in the study by completing a web-based questionnaire. After the ﬁrst e-mail, a follow-up e-mail was sent to 15,000 of those receiving the initial e-mail asking them to complete the questionnaire. As a result 1,174 respondents (1,153 usable) completed the web site questionnaire, an acceptable response rate of 5.2%.10 We note that web-based response rates are typically lower than those expected from traditional self-administered questionnaires. For example, Sheehan (2001) notes in his meta-analysis of web-based response rates, that the low-end of the range is 6–7%, while Smith (1997) indicates the present rate corresponds closely with other e-mail surveys. To test for nonresponse bias, Armstrong and Overton (1977) suggest t-tests comparing mean responses on major variables from early respondents with those of late respondents. There are no signiﬁcant differences between early and later respondents except that the former score higher on Concern for Others.11 The major risk in the present study is a Type II error (failure to ﬁnd a hypothesized relationship) because, arguably, individuals high on Career Ambition are more likely to be tempted to commit egregious acts and would be less likely to respond. Thus, the signiﬁcant ﬁndings (reported later) would potentially have been stronger with a higher response rate. Demographic characteristics of the respondents are depicted in Table 4. The average respondent is 44 years old, male (61.7%), has a hierarchical rank of 4.88 (1 ¼ lower-level, 7 ¼ top-level executive) and has been employed by their present employer for over 8 years. Approximately half have some form of certiﬁcation. They are typically upper mid-level accountants working in industry, and hence would likely understand and intelligently respond to the questions posed in our survey. Furthermore, they would

82

Table 3. Decision Scenarios – Descriptive Statistics (n ¼ 1, 153, 1 ¼ Not at All Likely, 5 ¼ Very Likely). Summary of Ethical Decision-Making Scenarios

Mean

S.D.

Evading taxes

Based on Dennis Kozlowski, former CEO of Tyco, Inc., who allegedly requested that an art consultant remove a $425,000 painting from his luxury apartment and ship it to Tyco ofﬁces, where an employee allegedly signed for it and immediately reshipped it to the Kozlowski apartment. The action was orchestrated to avoid New York state taxes on the transaction. Consequently, we created a scenario involving Native American art that was similarly being ‘‘shipped’’ to corporate ofﬁces to evade taxes. Based on the alleged behavior of Andrew Fastow, convicted felon and former CFO of Enron, and involves self-aggrandizement. Fastow created numerous special entities, usually partnerships, whose main purpose was to transfer debt from Enron’s balance sheet. While Fastow controlled some of these entities, he went a step further and had a personal investment stake in others. Thus, he was in fact dealing with himself. Consequently, we developed this scenario where respondents were asked how likely they were to allow their employer’s ﬁrm utilize a vendor in which they had a personal interest, even though other vendors would be more advantageous for their employer. Based on the indictment of Martha Stewart, founder and former president of Martha Stewart Omnimedia, Inc. She allegedly received insider trading information from the now convicted former CEO of ImClone, Inc., Sam Waksal. It is alleged that when Waksal learned that an important cancer-ﬁghting drug developed by ImClone would not be approved for use by the FDA, he called Stewart before the information was made public. Stewart then allegedly sold her investment in ImClone stock based on this ‘‘insider’’ information (Brady, 2002). Consequently, we created a scenario involving insider trading where our respondents were asked how likely they were to use insider information to avoid a serious loss they would face on a personal investment.

1.30

0.71

1.20

0.51

2.19

1.19

Self-dealing

Insider trading

FRANK COLLINS ET AL.

Variable Name

Converting allowance

Based on accounting difﬁculties at MCI WorldCom, WorldCom transferred more than $3.8 billion in expenses to capital accounts over ﬁve quarters (Drucker and Sender, 2002) and has agreed to a $750 million ﬁne for ‘‘falsifying ledgers to record billions of dollars in operating expenses as capital expenses, allowing the company to claim a proﬁt when it was in fact losing money (Barrett, 2002).’’ Based on the WorldCom situation, respondents were asked how likely they were to capitalize a material amount of advertising costs rather than properly treating them as expenses. Based on MCI WorldCom and its manipulation of the allowance for doubtful accounts as a means of inappropriately managing income. WorldCom inﬂated accounts receivable by amounts that had been deemed uncollectible, resulting in a $2.6 billion pre-tax increase in net income (Sender, August 21, 2002). In our survey, respondents were asked how likely they would be to make a journal entry transferring a signiﬁcant amount of allowance for doubtful accounts to ‘‘Other Income,’’ an entry with no justiﬁcation in fact. Overall

1.50

0.81

1.13

0.49

1.46

0.50

Career Ambition vs. Concern for Others

Inappropriate capitalization

83

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Table 4.

Demographic Statistics (n ¼ 1, 153).

Age Gender Educational level (highest attained) (%) Bachelor’s degree Some graduate Graduate Hierarchical level (1 ¼ low, 7 ¼ high) Job tenure (years) Area of worka (%) Accounting Marketing/sales Information systems Finance Consulting Type of business (%) Manufacturing Retail Construction Utilities Communications Health care Personal services Other a

44.02 38.3% female, 61.7% male 43.9 12.7 41.4 4.88 8.14 79.4 4.1 15.9 48.7 1.6 62.1 6.3 5.0 6.7 4.5 9.1 6.3 0.1

Since respondents selected multiple areas, percentages do not add to 100%.

likely be in a position where they could potentially engage in the types of egregious actions posed in our scenarios.

LISREL LISREL 8.12 (Jo¨reskog & So¨rbom, 1994), a structural equation computer program and methodology, is used to test relationships among our variables. LISREL shows the structure of relationships among multiple variables, and it is superior to regression and ordinary path analysis because it is not subject to multicollinearity problems and provides signiﬁcance levels for the path coefﬁcients (Smith & Lagﬁeld-Smith, 2004; Jo¨reskog & So¨rbom, 1989). We note that ‘‘contrary to ﬁrst generation statistical tools such as regression, LISREL allows one to answer an interrelated set of research questions in a single, systematic and comprehensive analysis that takes into account measurement error as an integral

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model part and includes confirmatory factor analysis as part of the measurement model’’ (Gefen, Straub, & Boudreau, 2000, p. 27).12 The measurement model within LISREL indicates how well the latent variables form our composite variables. The PHI matrix of our LISREL analysis indicates virtually no intercorrelations between the latent factors (0.07), and Fig. 1 indicates that all paths to the latent exogenous variables, Career Ambition and Concern for Others, and the latent endogenous variable, Egregious Decisions, are signiﬁcant at p ¼ 0.001. Additionally, the composite reliability indices of all composite variables are equal to 0.78, which indicates satisfactory reliability.13 The LISREL structural model can be used to determine the validity of the relationship among experimental variables, as well as the strength of the relationship (discussed in the following section). LISREL analytics indicate that we have a high-quality model. All of the indicator variables load most highly on the intended (latent) composite variables. Also, the model ﬁt indices (NFI ¼ 0.94, NNFI ¼ 0.95, CFI ¼ 0.96, GFI ¼ 0.96, AGFI ¼ 0.95) are allZ0.90, an indication of satisfactory discriminant validity (Bagozzi & Yi, 1988; Shook, Ketchen, Hult, & Kacmar, 2004). CA1

0.97

CA2

0.94

CA3

0.91

CA4

0.94

CA5

0.48

CA6

0.51

CFO1

0.47

CFO2

0.62

CFO3

0.37

CFO4

0.54

CFO5

0.38

CFO6

0.37

CFO7

0.34

Fig. 1.

0.41

EVADING TAXES

0.29

SELF-DEALING

CAREER AMBITION 0.29 EGREGIOUS ACTS

0.51

INSIDER TRADING

-0.27 CONCERN FOR OTHERS

0.43 RMSEA =0.04 NFI = .94 NNFI = .95 CFI = .96 0.27 AGFI= .95 Critical N = 508.17 Degrees of Freedom = 132 Chi-Square = 389.25, p < 0.01

INAPPROPRIATE CAPITALIZATION

CONVERTING ALLOWANCE

LISREL Results for Research Model (n ¼ 1,153). Note: Survey item detail appears in Tables 1–3. (All paths are signiﬁcant at po0.001).

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Having evaluated the reliability and validity of our variable measures and model, we next present tests of hypotheses by examining the strength of the relationship among our experimental variables.

RESULTS Tests of Hypotheses The hypotheses relating the Career Ambition and Concern for Others independent variables with the dependent variable, Egregious Decisions, are examined in Fig. 1. It is apparent that the independent variables relate to the dependent variable as hypothesized. Namely, individuals with higher Career Ambition have a higher probability of making Egregious Decisions (standardized coefﬁcient ¼ 0.29), while individuals with higher Concern for Others are not as likely to make Egregious Decisions (standardized coefﬁcient ¼ 0.27). Furthermore, the model statistics are strong (w2 ¼ 389.25, pp0.001, 132 df, GFI ¼ 0.96, AGFI ¼ 0.95, CFI ¼ 0.96, NNFI ¼ 0.95, and RMSEA ¼ 0.041) and path t-values are signiﬁcant at p ¼ 0.001. To ensure that the signiﬁcant w2 was attributable to sample size, we examine the Critical N, whose value of 508.17 allows the signiﬁcant w2 to be ignored.14 Consequently, we fail to reject the null version of H1 and H2, which were stated in positive form (i.e., with directional predictions).

Additional Analyses While the objective of our analysis is to examine the effects of Career Ambition and Concern for Others on likelihood to make unethical decisions, it is interesting to examine the relationships between the independent variables and each of the decision-making scenarios. In Table 5, we present LISREL results for each scenario to provide greater insight about relationships among the individual scenarios. While the effects of the independent variable measures vary somewhat across situations, the correlations and LISREL results conﬁrm the overall study results that Career Ambition and Concern for Others are signiﬁcantly related to the composite variable, Egregious Decisions, as well as each of the unethical decision-making scenarios. The LISREL results in Table 6, Panel A reafﬁrm the results of Table 5 that the independent variables have their weakest association with Insider

Career Ambition vs. Concern for Others

Table 5.

87

Comparison of LISREL Results for Individual Scenarios.

Career Ambition Concern for Others

Evading Taxes

Self-Dealing

Insider Trading

Inappropriate Capitalization

Converting Allowance

Egregious Decisions (Composite Variable)

0.25 0.33

0.35 0.21

0.14 0.12

0.27 0.18

0.22 0.32

0.29 0.27

76 237.47 (P ¼ 0.0) 0.97

76 234.36 (P ¼ 0.0) 0.97

76 242.09 (P ¼ 0.0) 0.97

76 230.54 (P ¼ 0.0) 0.97

132 389.25 (P ¼ 0.0) 0.96

Goodness of fit statistics Degrees of freedom 76 232.88 Minimum ﬁt (P ¼ 0.0) function w2 Goodness of ﬁt 0.97 index (GFI) 0.96 Adjusted goodness of ﬁt index (AGFI) Comparative ﬁt 0.97 index (CFI) Non-normed ﬁt 0.96 index (NNFI)

0.96

0.96

0.96

0.96

0.95

0.97

0.97

0.97

0.97

0.96

0.96

0.96

0.96

0.96

0.95

Trading. In Panel B of Table 6, Career Ambition and Concern for Others are signiﬁcantly related to each of the individual scenarios in the anticipated direction. Most interesting are the relationships with Insider Trading. Insider Trading has the highest mean score among respondents in terms of their likelihood to engage in the unethical behavior (see Table 3), and correlations between both the independent variables and Insider Trading are relatively lower than most of the other scenarios. Perhaps insider trading is perceived as less unethical or a ‘‘victimless crime.’’ Jones (1991) suggests that perceptions of the closeness of victims (proximity) affect perceptions of ethicality. In addition to analyzing our main relationships, pairwise correlation coefﬁcients with our composite demographic variables provide additional insights (see Table 6).15 From Panel B of Table 6, we note that Egregious Decisions is negatively correlated with the CPA designation (0.065, pp0.05), as well as respondents’ ages and tenure (on the job), 0.099 and 0.095 (pp0.01, respectively). Interestingly, none of the other demographic items (e.g., certiﬁed ﬁnancial analyst (CFA) and certiﬁed management accountant (CMA) designations, gender, rank, etc.) are signiﬁcantly related to the dependent variable. Although no relationships were hypothesized, it appears older respondents and those with more time on the job are less likely to make egregious decisions. To further examine the signiﬁcant negative correlation, the

Career Ambition

Concern for Others

Panel A: Individual scenarios and independent variables Career Ambition 1.000 Concern for Others 0.099** 1.000 Evading taxes 0.172** 0.188** Self-dealing 0.173** 0.081** Insider Trading 0.159** 0.123** Inappropriate 0.208** 0.137** capitalization Converting 0.106** 0.149** Allowance Egregious Decisions

Correlation Coefﬁcients.

Evading Taxes

Self-dealing

Insider Trading

1.000 0.374** 0.310** 0.248**

1.000 0.327** 0.254**

1.000 0.243**

1.000

0.282**

0.259**

0.254**

0.390**

Higher Level

1.000 0.099**

1.000

0.074**

0.013

1.000

0.088** 0.051* 0.026 0.009 0.057* 0.012 0.112** 0.013

0.026 0.075** 0.016 0.049* 0.046 0.032 0.031 0.060*

0.266** 0.138** 0.052* 0.007 0.001 0.060* 0.081** 0.038

*Signiﬁcant at 0.05 level (one-tailed). **Signiﬁcant at 0.01 level (one-tailed).

Age

Gender

Tenure

Education

1.000 0.156** 0.391** 0.095** 0.050 0.074* 0.049* 0.009

1.000 0.113** 0.092** 0.101** 0.100** 0.004 0.014

1.000 0.060* 0.030 0.052* 0.012 0.006

1.000 0.154** 0.047 0.036 0.021

Inappropriate Capitalization

CMA

Converting Allowance

1.000

CFM

1.000 0.346** 1.000 0.104** 0.083** 0.093** 0.107**

CPA

CIA

1.000 0.021

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FRANK COLLINS ET AL.

Panel B: Demographic variables Egregious 1.000 Decisions Career Ambition 0.251** Concern for 0.205** Others Hierarchical 0.057* level Age 0.099** Gender 0.008 Tenure 0.095** Education 0.036 CMA 0.037 CFM 0.014 CPA 0.065* CIA 0.030

Career Ambition Concern for Others

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Table 6.

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sample was partitioned into two groups (younger group one-half standard deviation less than the mean age (44.25 years); older group with age greater than one-half standard deviation of the mean age (48.70 years)). The younger workers were signiﬁcantly more likely to commit Egregious Decisions than the older workers (t-value ¼ 2.94, p ¼ 0.03). Perhaps one becomes ‘‘older and wiser.’’ Also, we note a signiﬁcant negative correlation between Career Ambition and Concern for Others, 0.099 (pp0.01). This is intuitively appealing on an overall basis as individuals with higher Career Ambition are not as likely to have a higher level of Concern for Others; however, our data include instances where individuals are high on both measures (composite measure of four to ﬁve for each). This is consistent with Jensen (1994), who notes that self-interest does not preclude an individual from possessing altruistic tendencies, and Jensen and Meckling’s (1994) suggestion that individuals who exhibit both self-interest and altruism face conﬂict.16

DISCUSSION OF RESULTS In recent years, it has become evident that ethical decision making by accountants and other individuals within business organizations is a relevant social issue. In fact, Henry (2004, p. 80) notes that ‘‘abuse of accrual accounting is pervasive across a broad swath of companies,’’ and that in a recent survey, 20% of corporate executives would look for loopholes to manage earnings to meet targets. As a means of response, talk of new or enhanced corporate codes of conduct and the necessity of changes to corporate climates and culture ﬁlls the popular business press. While ‘‘ethical tone’’ and ‘‘control environment’’ are important audit risk factors, both the tone and environment are reﬂective of the attitudes of individuals comprising organizations. While such measures as organizational structure, compensation systems, and controls affect tone and environment, it is the constituent individual attitudes that reﬂect and affect the overall organizational climate. Consequently, the present study focuses on salient individual attitudes that affect this climate, Career Ambition and Concern for Others, and their ability to predict the intention to engage in unethical behavior. Our data indicate that individuals in the study with higher career ambition are associated with a higher likelihood to make egregious decisions such as those depicted in our scenarios than those with lower career ambition. This is consistent with prior research which ﬁnds that the availability of extrinsic

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rewards elicits unethical decision making (Hegarty & Sims, 1978), and that ‘‘money’’ has the potential to energize and corrupt (Laming, 2004). Our results also suggest that Concern for Others, a variable related to spirituality, is associated with a lower likelihood of making egregious decisions. Since prior research has shown that spirituality (broadly deﬁned) in the workplace is related to higher levels of creativity, honesty and trust, personal fulﬁllment, commitment, and organizational performance (Krishnakumar & Neck, 2002), elements of spirituality or Concern for Others may be of interest to all organizations. The mean responses for our composite variables on a scale of 1 (low) to 5 (high) indicate a reasonably high level of Concern for Others (4.08, s.d. ¼ 0.51), a moderate level of Career Ambition (2.16, s.d. ¼ 0.86), and low levels of likelihood to make an Egregious Decision (range 1.13–2.19, s.d. range 0.49–1.20). Consequently, our average respondent, an upper mid-level accountant working in industry, is not likely to engage in these egregious decisions. Less comforting is that MBA students in our pilot study scored signiﬁcantly higher on Career Ambition and Egregious Decisions. While the pilot study’s sample is limited and it is inappropriate to compare the two samples, there is the suggestion that the next generation of MBAs is more self-centered and more likely to engage in egregious decisions.17 Perhaps MBA programs should include genuine required ethics courses and meaningful emphasis in all classes throughout their curriculum. Given that SAS 99 (AICPA, 2002) identiﬁes incentives, opportunity, and personal values as conditions often associated with fraud, our ﬁndings suggest that elements of Career Ambition and Concern for Others should be considered in the design of control systems. For example, when designing or identifying internal controls for compliance under the Sarbanes–Oxley Act, boards of directors and auditors should be cognizant of how Career Ambition elements may motivate unethical actions. On the other hand, while internal controls may be helpful in defusing the tendency for employees to rationalize their behavior (Albrecht, 2003), they cannot be relied upon to increase Concern for Others. Hence, the adoption of workplace systems, such as those outlined by Kerns (2003) or Wong (2002), which take into account values and attitudes or social–spiritual capital, may be helpful. Given the present ﬁndings, it is logical that our variables, Career Ambition and Concern for Others, could be used in admitting new employees to an organization or considering others for promotion. To the extent that personality or aptitude tests are given to potential employees or those being considered for promotion to positions where there is signiﬁcant risk deriving from unethical behavior, it would be useful to measure the ethical

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posture of these persons. Given the sensitivity of such questions, as well as the litigious society in which we operate, indirect measurement may be required. For example, Gebler (2005) recommends adoption of a Culture Risk Assessment which examines employee behaviors and values to evaluate the potential for unethical behavior within an organization. The assessment categories include employee values that reﬂect self-interest and employee values that reﬂect the ‘‘Common Good.’’ The theory behind a Culture Risk Assessment is that in addition to monitoring compliance with corporate rules, regulations, and internal control processes, organizations must be aware of employee behaviors and values to reduce the risk of unethical behavior, scandals, and criminal prosecution. In order to fully understand ethical behavior in the workplace, it is important to consider not only individual differences, but the impact of systems in the workplace on that behavior. The interaction between individual values and systems is complex, and the effects are reciprocal. Employees react differently to punitive and lax control systems over ethical behavior, and employees’ choices and inﬂuence often lead to changes in the systems. Employees may even self-select into organizations with control systems that are compatible with their moral reasoning, career ambition, or concern with others. On the other hand, they may gravitate toward systems they see as capable of manipulation. Organizations may recruit employees for certain skill sets and inadvertently impact control systems involved in monitoring ethical behavior. Thus, it seems important to evaluate individual differences as people enter the organization. Finally, since the relationship of age to Career Ambition and Egregious Decisions is negative (see Table 5), older employees may be effective in promoting teamwork and communicating the ‘‘big picture’’ to younger employees, so they will not be as focused on Career Ambition and will perhaps be less likely to engage in egregious behavior. As noted previously, older workers were signiﬁcantly less likely to make Egregious Decisions and would potentially be effective role models. This type of inﬂuence or training may help to limit fraud by directly addressing the attitude (Loebbecke, Eining, & Willingham, 1989) or rationalization (Albrecht, 2003) portion of the SAS 99 fraud triangle. Consistent with the work of Kohlberg (1976) and Wheat (1991), this age effect seems to be maturational rather than simply generational. Though this cannot be shown conclusively apart from longitudinal research, the work of Rest (1986) and Kohlberg (1976) offers extensive support for the idea of moral development over time.

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SUGGESTIONS FOR ADDITIONAL RESEARCH Despite a low reported likelihood of engaging in egregious behaviors, the propensity for the management accountants surveyed to make egregious decisions was associated with both Career Ambition and Concern for Others. Organizations may beneﬁt from the knowledge that Career Ambition and Concern for Others can have a potential impact on accounting and ﬁnancial decision making. This may be important when addressing organizational issues (i.e., corporate environment, code of conduct, and internal control structure) or human resource issues (i.e., employee hiring and evaluation). While recognizing that incentives are often important to performance, corporate boards should be careful to structure those incentives in a way that will not entice employees to consider only self-interest. Furthermore, the organization has the opportunity to communicate openly about the values that ought to trump self-interest, but upper management is advised to act consistently in modeling and enforcing those values and setting what the Treadway Commission referred to as ‘‘the tone at the top.’’ The ﬁndings of the present study, when contrasted with the pilot study ﬁndings, provide strong motivation for additional research among MBA students, accountants, and nonaccountants to see if MBAs indeed have a higher propensity to make egregious decisions. Further, it seems appropriate to study more intensely the interaction between management accountants and their management counterparts to see how the likelihood of making egregious decisions is affected by relative power relationships, codes of ethics, and professional certiﬁcations. Can management accountants be relied on to help protect the public interest, and will that protection be enough to forestall future egregious behavior, at least to an important extent? Future work could look at egregious decisions that are truly egregious in that they violate not just externally imposed values, but important personal values that are clearly contrary to an individual’s value system.18 These issues remain to be resolved, but the answers are important to the marketplace and to the accounting profession. Finally, given our ﬁndings, researchers using previously established models of ethical decision making may wish to consider examining variables such as Concern for Others or Career Ambition, since there are a number of questions that are potentially impacted by these variables and the tension between them. For example, what is the impact of Career Ambition and Concern for Others on a CEO’s decision about layoffs of employees, or a board’s decision about a CEO’s compensation? What about their effect on

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managers’ promotion decisions regarding subordinates? How do these effects change over time?

Study Limitations The present research suffers from the usual limitations of survey methodology, including the potential presence of the ‘‘halo effect,’’ errors of severity/ leniency, equal scalar intervals, and artiﬁciality. Further, there has been so much publicity and notoriety associated with current scandals that our respondents may have been biased to appear less likely to make egregious decisions and toward having a higher Concern for Others than normal. In defense of the present study, the instrument used was carefully tested in a pilot study, one that not only involved completing a questionnaire, but also allowed respondents to make written and verbal comments on the questionnaire’s meaningfulness and understandability. The methodology was efﬁcient in generating a sample size large enough to isolate the relationships among our variables; however, while typical of large e-mail surveys, the response rate is a possible limitation. Unfortunately, e-mail survey response rates have been decreasing, possibly as a result of the insidious effect of ‘‘spam.’’19,20 Consequently, while this survey method allows for speedy and cost-effective data gathering, e-mail surveys face increasing challenges. Another limitation of this study is that we study ‘‘attitudes,’’ not actual behavior. Our study is premised on the belief that attitudes lead to behavior. Though this linkage is logical, it is not always demonstrated as easily as the linkage between thoughts and intentions, consistent with the temporal order of the four components of Rest’s (1986) framework of ethical decision making. Demonstrating the eventual linkage between thinking and behavior will always be a primary emphasis of expectancy theory researchers.21 Though supported by theory, we provide no proof involving actual behavior. Much remains to be done in understanding the role that management accountants can play in restraining unethical behavior in corporate settings. Publicity about these behaviors may attract attention to the problem, but it will not solve the problem. The current research enhances understanding of well-established decision-making models by closely examining the effects of two measures of personal values or attitudes on unethical decision making. We believe that understanding the relationships between our variables can have important corporate policy implications. Researchers have the potential to reduce society’s exposure to these behaviors by helping organizations to anticipate them before they happen.

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NOTES 1. Public outcry over these and other scandals prompted the U.S. Congress to enact the Sarbanes–Oxley Act, which established new accounting, auditing, and reporting requirements, created the Public Company Accounting Oversight Board, and now requires CEOs to attest to the accuracy of their ﬁrm’s ﬁnancial statements. 2. For example, Statement on Auditing Standards No. 99, Consideration of Fraud in a Financial Statement Audit, notes that otherwise honest individuals may commit fraud due to incentives; however, a culture of honesty and ethical behavior can prove a deterrent to fraudulent behavior. 3. Virtue refers to the individual’s character, while altruism refers to behavior consistent with virtuous character. Virtue does not preclude self-interest, but a preoccupation with self-interest would be unlikely in the virtuous person. 4. Each of these positive outcomes is considered an ‘‘extrinsic’’ outcome, since it is an externally generated consequence, as opposed to an ‘‘intrinsic’’ outcome, which is positive simply based upon personal, internal appeal to the individual (Gailbraith & Cummings, 1967). 5. LISREL is a path-analytic computer program and methodology developed by Jo¨reskog and So¨rbom (1989). 6. Spirituality is not strictly a religious concept because a spiritual person may be, but is not necessarily a ‘‘religious’’ person or a member of an organized religion. For example, witness the recent terror bombings in the name of a supreme deity as detailed by Malkin (2004) in ‘‘Let us remember correctly terror ‘in the name of Allah.’’’ 7. Historically, religious duties have had a signiﬁcant inﬂuence on those who take into account the interests of others. For example, Adam Smith (1976, p. 383) said that benevolence was no source of ‘‘solid happiness’’ except for those ‘‘thoroughly convinced’’ of the ‘‘y care and protection of [a] great, benevolent, and all-wise Being.’’ 8. In the pilot study, Wheat’s second dimension, awareness and connection to life itself, was eliminated because it did not make sense in the context of ﬁnancial and accounting decisions (e.g., ‘‘I read articles on health and peace’’ or ‘‘I experience a sense of the sacred in living things’’). 9. Coefﬁcient alphas for the composite variables in the pilot study were: Career Ambition (a ¼ 0.925), Concern for Others (a ¼ 0.758), and Egregious Decisions (a ¼ 0.736). 10. The sponsoring organization was not willing to send a follow-up e-mail to the entire sample. Had this been done, the overall response rate would have been higher. 11. This ﬁnding provides additional evidence that our instrument effectively measures Concern for Others, because respondents high on this dimension would likely be more prompt in responding due to their ‘‘concern’’ for the present researchers or with the ethical issues themselves. 12. While we utilized a two-stage approach involving conﬁrmatory factor analyses and a regression model (Anderson & Gerbing, 1988) in the pilot study, the present study employs the ‘‘full’’ LISREL model, which represents a multivariate statistical technique that combines conﬁrmatory factory analysis and econometric modeling for analyzing hypothesized relationships among latent variables. Anderson and Gerbing (1988) note that an interaction between the measurement and structural models in a ‘‘full’’ LISREL analysis may result in misspeciﬁcation of

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variables in the measurement model without an earlier, separate conﬁrmatory factor study to specify variables prior to their use in a full analysis. The pilot study provided the necessary ﬁrst step for the present study. More importantly, our task in the current study is to conﬁrm the model developed in our pilot study. Our objective is to show that our earlier model, which was exploratory, is corroborated and not disconﬁrmed by the data in the present study (Bollen, 1989; Hair, Anderson, Tatham, & Black, 1998; Jo¨reskog and So¨rbom, 1999). Whereas partial least squares (PLS) regression and regression-based techniques such as ANOVA and MANOVA focus on reducing variance in the ﬁnal model, ours compares the covariance structure of our previously developed model to a best possible ﬁt covariance structure extant in our current data, taking into account the interaction between the multiple components of the dependent variable. Consequently, LISREL is best suited for conﬁrmation of our research model (Gefen et al., 2000). 13. The composite reliability provides the same reliability assurance provided by Coefﬁcient a but is more appropriate in structural equation modeling (Shook et al., 2004). 14. Hoelter (1983) advises that a Critical N value greater than or equal to 200 allows one to discount a signiﬁcant w2 value. Also, Hayduk (1996) notes an excessive test power (i.e., a large n), ‘‘lead[s] to the rejection of worthwhile models’’ since ‘‘y the w2 test makes no allowance for the approximate, loose, rough, or simplifying nature of social science models (Hayduk, 1996).’’ 15. For this additional analysis, individual survey items related to each study variable were averaged. 16. While these works treat the phenomena of self-interest and altruism as distinct, they arguably may be interrelated in subtle, yet important, ways. We thank an anonymous reviewer for this observation. 17. This is consistent with research ﬁndings of the Kenan Institute for Ethics at Duke University. They note that longitudinal comparisons have demonstrated signiﬁcant increases in student cheating of late (http://www.academicintegrity.org/ cai_research.asp). 18. We thank an anonymous reviewer for this suggestion. 19. Bickart and Schmittlein (1999) and Sheehan (2001) report that response rates are declining for all types of surveys. 20. Tynan (2002) predicts that by 2006, e-mail users will receive on average 1,400 spam messages per year. 21. See Ajzen and Fishbein (1973), Fishbein and Ajzen (1975) and, more recently, Majd-Jabbari (1990) for discussions of the relationship between behavioral intention and overt action.

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Korac-Kakabadse, N., Kouzmin, A., & Kakabadse, A. (2002). Spirituality and leadership praxis. Journal of Managerial Psychology, 17(3), 165–182. Krishnakumar, S., & Neck, C. P. (2002). The ‘‘what,’’ ‘‘why’’ and ‘‘how’’ of spirituality in the workplace. Journal of Managerial Psychology, 17(3), 155–164. Laming, D. (2004). Understanding human motivation: What makes people tick? United Kingdom: Blackwell. Levinson, D. (1978). The seasons of a man’s life. New York: Ballantine Books. Loe, T. W., Ferrell, L., & Mansﬁeld, P. (2000). A review of empirical studies assessing ethical decision making in business. Journal of Business Ethics, 25(3), 185–204. Loebbecke, J., Eining, M., & Willingham, J. (1989). Auditors’ experience with material irregularities: Frequency, nature, and detectability. Auditing: A Journal of Practice and Theory, 9(1), 1–28. Louwers, T., Ponemon, L., & Radtke, R. (1997). Examining accountants’ ethical behavior: A review and implications for future research. In: V. Arnold & S. Sutton (Eds), Behavioral accounting research: Foundations and frontiers (pp. 48–88). Sarasota, FL: American Accounting Association. Lowensohn, S., & Collins, F. (2001). The role and perceptions of independent audit partners in the governmental audit market. Accounting and the Public Interest, 1(1), 17–41. Majd-Jabbari, M. (1990). Behavioral intention as a function of attitude toward the object, attitude toward the behavior, subjective norm, and direct experience. Doctoral dissertation, Indiana University. ProQuest Digital Dissertations database (Publication No. AAT 9020721). Malkin, M. (2004). Let us remember correctly terror ‘‘In the Name of Allah.’’ Houston Chronicle. http://www.freerepublic.com/focus/f-news/1215356/posts Martin, L. (1997). The relationship between spirituality and personality: A study of christian clergy. Dissertation, Abstracts International 9736598. ProQuest Digital Dissertations database (Publication No. AAT 9736598). Milliman, J., Ferguson, F., Trickett, D., & Condemi, B. (1999). Spirit and community at southwest airlines: An investigation of a spiritual values based model. Journal of Organizational Change Management, 12(3), 221–233. Nonis, S., & Swift, C. O. (2001). Personal value proﬁles and ethical business decisions. Journal of Education for Business, 76(5), 251–256. O’Fallon, M. J., & Butterﬁeld, K. D. (2005). A review of the empirical ethical decision-making literature: 1996–2003. Journal of Business Ethics, 59, 375–413. Petri, H. L., & Govern, J. M. (2004). Motivation: Theory, research and applications (5th ed.). Belmont, CA: Thomson Wadsworth. Piaget, J. (1932). The moral judgment of the child. New York: Free Press. Rest, J. R. (1986). Moral development: Advances in research and theory. New York: Praeger Publishers. Rutledge, R. W., & Karim, K. K. (1999). The inﬂuence of self-interest and ethical considerations on managers’ evaluation judgments. Accounting, Organizations and Society, 24, 173–184. Sender, H. (2002). Accounting issues at WorldCom speak volumes about disclosures. Wall Street Journal (August). Shamir, B. (1990). Calculations, values, and identities: The sources of collectivistic work motivation. Human Relations, 43(4), 313–332.

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CORPORATE GOVERNANCE SYSTEMS: AN ETHICS RESEARCH FRAMEWORK Steven M. Mintz ABSTRACT This exploratory chapter provides a research framework based on corporate governance systems that identify six areas for future study using and framing questions to stimulate research. The framework is developed by using selected corporate governance elements identified by Goergen, Manjon, and Renneboog (2004, p. 2) and the Treadway Commission’s depiction of an ethical control environment that was adopted by COSO. The six areas include (1) Virtue Ethics: Role of the External Auditor; (2) Ethical Tone at the Top: Audit Committee Responsibilities; (3) Custodial Responsibilities: The Role of the Board of Directors; (4) Fiduciary Responsibilities: The Role of the CEO; (5) Building Shareholder Trust: Financial Statements that ‘‘Present Fairly’’; and (6) Ethical Values: The Control Environment. The conceptual framework describes how each element within a corporate governance system interrelates with other elements (internal effect) and with external audit and regulatory requirements (external effect). Accounting researchers need to broaden their horizons to advance accounting ethics research. The issue of whether corporate governance systems operate in an ethical manner is a natural extension of earlier

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research that emphasized ethical reasoning, virtue ethics, and developing an ethical culture for an organization.

BACKGROUND In 1986, the American Accounting Association (AAA) issued its report, Future Accounting Education: Preparing for the Expanding Profession (Bedford Report) (American Accounting Association, 1986) that recommends professional accounting education should develop ‘‘an appreciation of ethical standards and conduct.’’ Since that time a variety of research has elaborated on this idea, which include (1) describing moral development and accounting education (Armstrong, 1987); (2) identifying what should be the goals of accounting ethics education (Loeb, 1988); (3) developing an ethical decision-making model to facilitate learning (Langenderfer & Rockness 1989); (4) exploring how ethical judgments are made in accounting (Ponemon & Gabhart, 1990; Ponemon & Glazer, 1990; Ponemon, 1992); (5) philosophizing auditor obligations and the moral point of view (Gaa, 1992); (6) analyzing factors affecting the cognitive moral development of accountants and auditing students (Shaub, 1994); (6) exploring the role of virtue in decision making (Mintz, 1995; Thorne, 2003); and (7) discussing virtue in the auditing context (Libby & Thorne, 2003).

ETHICS IN ACCOUNTING: CURRENT ISSUES Since 2000, the focus of research has expanded to include how and why ﬁnancial frauds at companies such as Enron and WorldCom could have happened and what is needed in the future to prevent another wave of accounting scandals. For example, Zeff (2003, pp. 269–275) identiﬁes at least two reasons for a shift in culture of the accounting profession that may have enabled frauds to occur. These include (1) the growth of consulting services from the mid-1970s onward that created challenges to audit independence and an environment supportive of cross-selling services to and with clients;1 and (2) the emphasis on analysts’ earnings forecasts adding to the pressure on CEOs (pushed down to CFOs) to achieve earnings targets. The result is to heighten the client pressure on auditors to go along with management’s attempts to ‘‘cook the books.’’2 Several researchers have commented on the change in culture. Wyatt (2004) notes the culture of accounting ﬁrms has changed from ‘‘a central

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emphasis on delivering professional services in a professional manner to an emphasis on growing revenues and proﬁtability.’’ Wyatt (2004, pp. 49–53) calls for reestablishing professionalism and an ethical tone at the top of accounting ﬁrms that balances the rewards of attracting new clients with rewards to those accounting professionals ‘‘who have been particularly effective in their technical and professional performance.’’ He considers technical and professional performance to encompass ethical behavior in carrying out responsibilities. Gaa and Thorne (2004) in their introduction to the Special Issue on Professionalism and Ethics that was published in Issues in Accounting Education note that accounting education research has devoted signiﬁcant attention to studying the link between accountants’ ethical reasoning process and their professional judgment (see Thorne, 2003). However, Gaa and Thorne (2004, p. 2) also point out that ‘‘less attention has been paid to questions of character and value on the one hand, and to institutional issues on the other.’’ Bernardi’s (2004) suggestion might provide a direction for future research in accounting ethics. He identiﬁes the strategy of ‘‘viewing ethics not as a subﬁeld of accounting, but instead as a ﬁeld within business.’’ This strategy takes on even greater signiﬁcance with respect to the Sarbanes–Oxley Act (SOX) and the requirement to enhance the ethical culture of the public company. Accounting ethics research has been conspicuously lacking as it relates to how an ethical control environment be established and what approaches might be used to assess whether internal controls conform to professional standards. The purpose of this chapter is to explain how accounting educators might extend the boundaries of ethics research by focusing on an ethical corporate governance system and identifying the elements of that system. Research studies on corporate governance emphasize the role of speciﬁc elements in the system but these studies do not attempt to explain how to build ethics into the system. For example, Cohen et al. (2004) link corporate governance to the quality of ﬁnancial reporting. While the authors do not deﬁne the term, they use earnings management, ﬁnancial restatements, and fraud to illustrate events that prevent quality ﬁnancial reports and identify the board of directors, audit committee, external auditor, and the internal audit as important parts of the system. Under Section 404 of the SOX (H.R. 3763), the external auditor is required to assess management’s report on internal controls over ﬁnancial reporting. The 1994 report of the Committee of Sponsoring Organizations of the Treadway Commission (COSO), Internal Control – Integrated Framework, notes that the ‘‘control environment sets the tone of an

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organization, inﬂuencing the control consciousness of its people.’’ The control environment includes the integrity, ethical values, and competencies of the entity’s people; management’s philosophy and operating style; the way management assigns authority and responsibility and organizes and develops its people; and the attention and direction provided by the board of directors. To build ethics into the corporate governance system requires an ethical, underlying internal control structure. An important question with respect to the control environment is,‘‘Can external auditors be expected to evaluate whether an organization sufﬁciently incorporates ethics into the control environment if they themselves do not act ethically in carrying out professional responsibilities and dealing with the pressures that may be imposed on them by top management?’’ A healthy dose of skepticism feeded by objectivity and integrity might provide the basis to deal with those pressures and act ethically. The accounting ethics research to date has emphasized the ethics of accountants and auditors including ethical decision making and traits of character (virtues) that enable ethical reasoning and judgment. However, there is a dearth of research on what the auditor should look for in evaluating the control environment, an integral part of an effective system of corporate governance. This chapter suggests that the link to create future research opportunities for accounting educators is to focus on corporate governance and how to develop ethical components of the system. The rest of the chapter is organized as follows. The next section describes the elements of the corporate governance system and why internal and external control mechanisms exist to monitor management behavior and provide a framework to achieve accurate and reliable ﬁnancial reporting. The following section identiﬁes and explains six areas for future research in corporate governance systems that have strong ethics components. A discussion follows of the educators’ roles in teaching students about the need for an ethical control environment to support the ﬁnancial reporting process. The chapter concludes by looking at future issues including the possibility of curricula development in accounting ethics and corporate governance.

FOUNDATIONS OF CORPORATE GOVERNANCE SYSTEMS Typically, the phrase ‘‘corporate governance’’ invokes a narrow consideration of the relationship between the ﬁrm’s capital providers and top management as mediated by its board of directors (Hart, 1995). Shleifer and

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Vishny (1997) deﬁne corporate governance as the process that ‘‘deals with the ways in which suppliers of ﬁnance to corporations assure themselves of getting a return on their investment.’’ Goergen, Manjon, and Renneboog (2004, p. 2) point out that a corporate governance regime typically includes the mechanisms to ensure that the agent (management) runs the ﬁrm for the beneﬁt of one or more principals (shareholders, creditors, suppliers, clients, employees, and other parties with whom the ﬁrm conducts its business). The mechanisms include internal ones such as the board of directors; its committees including the audit committee; executive compensation policies; and internal controls. External measures include monitoring by large shareholders and creditors (in particular banks); external auditor examination and reporting; the regulatory framework of a securities exchange commission; the corporate law regime; and stock exchange listing requirements and oversight. The Report of the National Commission on Fraudulent Financial Reporting (Treadway Commission Report 1987) emphasizes the need for strong internal controls including giving the internal auditors direct and unrestricted access to the audit committee. The recommendations of Treadway Commission were adopted by COSO and the framework is considered to represent the elements of a sound system of internal controls that contributes to an ethical organization culture. Fig. 1 depicts the Treadway Commission framework that is used later on in the chapter to provide framing questions for ethics research in corporate governance. By taking selected internal elements identiﬁed in the COSO framework and external relationships identiﬁed by Goergen et al. (2004) as external reporting and regulatory requirements, a new framework has been developed to show how these elements interrelate. Fig. 2 describes the corporate governance framework that will be used to identify research areas explained later on in the chapter. The framework consists of internal elements depicted through continuous lines that connect reporting responsibilities and oversight roles while the broken lines link to the external environment and regulatory controls. For example, the audit committee has oversight responsibility for external audit matters that may get reported down the line from the CEO to the accounting function and inﬂuence future controls and reports. Under the SOX the Public Company Accounting Oversight Board (PCAOB) and the SEC have oversight responsibilities for the external audit and audit report, management’s report on internal controls (Section 404), and the certiﬁcation of ﬁnancial statements by the CEO and CFO (Section 302). Therefore, a broken line is used to connect these functions and an arrow

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Audit Committee of the Board of Directors

Board of Directors

Cheif Executive Officer Internal Audit Function

Cheif Finanical Officer Controller Accounting Department - Internal Accounting Controls -Accounting System

Legal Department

Financial Reports

Fig. 1.

Internal Control Environment – ‘‘Corporate Culture.’’ Note: This diagram ﬁrst appeared in the Treadway Commission Report.

reﬂects the direction of the activity. These ﬂows reﬂect external and institutional elements including the reporting requirements to the PCAOB and the SEC. The external reporting requirements are depicted on the outer perimeter of Fig. 2 while internal processes are in the inner part of the diagram.

Enhanced Ethical Obligations for the Audit Committee The SOX requires that the audit committee should be composed of at least three independent members ‘‘who are neither [currently] employed by the corporation nor were so employed within the previous two years.’’ One member must be a ﬁnancial expert to help other members and the board to gain a greater understanding of the ﬁnancial statements. One common element in all of the recent accounting scandals is that the audit committee did not play a meaningful role in stopping the fraud. In some cases the members of the committee claimed they were kept in the dark by top management.3

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Independent Auditors

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Board of Directors Legal Department

External Audit Matters Audit Report (PCAOB/ SEC)

Independent Auditor Assessment of Management’s Report

Cheif Executive Officer

Internal Audit Function

External Audit

Section 404: Management Report on Internal Controls (PCAOB/SEC)

Oversight

Accounting Function Chief Finanical Officer Controller

Section 302: Certification of Financial Statements (PCAOB/SEC)

Internal Controls/Control Environment

Financial Statements

Fig. 2.

Corporate Governance Systems: An Ethics Research Framework.

The role of the audit committee relates to its relationship with the external auditors. Fig. 2 depicts this relationship with a continuous line and an arrow from the independent auditors to the audit committee. This shows the reporting relationship of the external auditors to the audit committee especially when external audit matters such as differences on accounting principles exist. SOX enhances audit committee responsibilities to include (1) serving as a communication link between the external auditor and the board; (2) communicating with the external auditors with respect to management’s receptivity to recommended changes in the accounting principles and ﬁnancial reporting practices; (3) reviewing the corporation’s annual ﬁnancial statements, the results of the external audit, the auditor’s report, and management’s responses to audit recommendations;

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(4) reviewing any signiﬁcant disputes between management and the external auditor that arose in connection with the preparation of those ﬁnancial statements; (5) considering, in consultation with the external auditor, the adequacy of the corporation’s internal controls; (6) considering major changes and other major questions of choice respecting the appropriate auditing and accounting principles and practices to be used in the preparation of the corporation’s ﬁnancial statements when presented by the external auditor, a principal senior executive, or otherwise.

The Role of Accounting in Monitoring Management Behavior Statement of Auditing Standards (SAS) No. 55 (American Institute of Certiﬁed Public Accountants, 1990) characterizes internal control as a process – effected by the entity’s board of directors, management, and other personnel – designed to provide reasonable assurance regarding the achievement of objectives in the following categories: (1) reliability of ﬁnancial reporting; (2) effectiveness and efﬁciency of operations; and (3) compliance with applicable laws and regulations. The ﬁnancial statements prepared by management require the involvement and oversight of internal accountants and internal auditors. Another common element in all of the recent accounting scandals is that the CFO participated in the fraud. In the case of WorldCom, the internal auditors were responsible for stopping the fraud. The ethics of these ﬁnancial professionals play an essential role in preventing fraud. Management has a stewardship responsibility to protect company assets. An important component of internal control includes the processes in place to safeguard company assets. As the recent scandals indicate, even the best internal control system will fail if top management overrides the controls or the directors turn away from their responsibilities. For example, top executives at Tyco used hundreds of millions of dollars from interest-free loans for personal purposes. The board claimed to have been uninformed about the nature and purpose of the loans. The SEC oversees ﬁnancial reporting in the U.S. and the commission develops implementation procedures for parts of SOX. Section 302 of the Act requires the CEO and CFO to certify the accuracy of the ﬁnancial reports ﬁled with the commission. The ﬁrst test case under the Act was the

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alleged certiﬁcation of materially false and misleading ﬁnancial statements by the CFO and CEO of HealthSouth. The CFO admitted his guilt but the CEO was acquitted of all charges.4 While the management is responsible for the preparation of the ﬁnancial reports, the SEC requires public-owned companies to hire independent auditors to render opinions on whether the statements present fairly the ﬁnancial position, results of operations, and cash ﬂows in accordance with generally accepted accounting principles (GAAP). As previously mentioned, the pressures that can be imposed by top management on the external auditors (as well as the CFO) test the moral fortitude of these accounting professionals in carrying out their ﬁnancial reporting responsibilities.

IDENTIFYING AREAS FOR FUTURE RESEARCH Virtue Ethics: Role of the External Auditor Virtue ethics is an agent-based approach to ethics that emphasizes character traits. As Mintz (1995, pp. 259 and 265) points out, it is the virtues that enable accountants to withstand management pressures that might otherwise overwhelm professional judgment. Virtue ethics could be applied to external and internal auditors, the audit committee, the board of directors and so on. To illustrate its application, an example is provided of its applicability to external auditors. Libby and Thorne (2003, p. 1) note that while auditors’ ethics relate to their formulation of professional judgment, auditors’ virtue relates to their exercise of professional judgment. They identify auditors’ intellectual virtues as deﬁned by the Canadian accounting community through a survey of 400 chartered accountants. The relative importance of the top 7 out of 21 virtues identiﬁed by the accountants are (in order of ranking) (1) integrity, (2) truthfulness, (3) independence, (4) objectivity, (5) dependability, (6) principle, (7) healthy skepticism. The last virtue is important because it mirrors the requirement of SAS No. 99, Consideration of Fraud in a Financial Statement Audit (AICPA, 2002), that the auditor should exercise professional skepticism when considering the possibility that a material misstatement in the ﬁnancial statement exists due to fraud. Also, other virtues link to skepticism including integrity and objectivity. Professional skepticism is used to illustrate how to take a virtue and develop framing questions for further research.

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Framing question: How can an auditor develop a ‘‘healthy dose of skepticism?’’ What are the virtues that enable auditors to approach the engagement with an appropriate sense of professional skepticism rather than a more trusting attitude? Does it help to have an objective inquiring-mind? What are the characteristics of a skeptical approach to auditing? How might the control environment support or possibly create a barrier to exercising an inquiry-based approach to auditing?

Ethical Tone at the Top: Audit Committee Responsibilities Just as auditors should approach their responsibilities with a healthy dose of skepticism, the audit committee needs to do the same. The three independent members of the committee are not there to rubber-stamp everything the management does, as was the case in so many accounting scandals. Instead, the committee should set a tone that helps to create a ﬁnancial reporting system that promotes accuracy, reliability, and transparency. Thorne’s (2003) research on auditor virtues ﬁts in well and might be extended to include the role and responsibilities of the audit committee. Framing question: What are the features of the control environment that enables the audit committee to set a proper tone at the top? How can the audit committee demonstrate moral support for the work of the external auditors? What are the virtues that enable audit committee members to exercise independent (from management) oversight of the ﬁnancial reporting process? What are the elements of a ‘‘ﬁnancial expert’’ and how can it be linked to an ethical control environment?

Custodial Responsibilities: The Role of the Board of Directors The board of directors has a crucial role to play in mitigating the risks inherent in the principle–agent relationship. Directors are guardians of shareholder interests. A sound corporate governance system requires that directors should do everything in their power to protect shareholders’ assets.

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An important responsibility of the board is to pursue corporate ethics below the surface. By understanding what goes on behind the fac- ade of the code of ethics, the board ensures that it meets its responsibility to the shareholders that the company is producing transparent ﬁnancial reports. Transparent ﬁnancial reporting provides reliable, consistent, and sufﬁciently detailed information that reﬂects the underlying current and expected future condition of the company in a clear and understandable manner. Transparent ﬁnancial information meets the test of ethics because it is accurate and dependable. Framing question: What systems are currently in place to foster transparent ﬁnancial reporting? How does the board (or audit committee) evaluate the statements made by the CEO and CFO in compliance with the certiﬁcation requirements of Section 302 of the SOX? How does the board (or audit committee) evaluate whether the CFO (or chief accounting ofﬁcer) has met her ethical responsibilities under Section 406 of Sarbanes–Oxley? What statements are made in the annual report and 10-K Report ﬁled with the SEC that shed light on whether top management has met its ﬁduciary responsibility to shareholders as envisioned under Sections 302 and 406?

Fiduciary Responsibilities: The Role of the CEO An ofﬁcer or director is required to act as a trustee on behalf of the corporation and its shareholders (Gottlieb v. McKee, 1954). This standard is generally met by managing the corporation with unselﬁsh loyalty and the utmost concern for the corporation and its shareholders. The CEO should not use her position to make a personal proﬁt or to gain an unfair advantage. Examples of situations that would violate the ﬁduciary responsibilities of a CEO include fraud, self-dealing, misappropriation or diversion of corporate assets, and similar matters involving potential conﬂicts between the CEO’s interest and the corporation’s welfare. A large number of businesses are incorporated in Delaware. The Delaware Chancery Court serves as an outlet for shareholder derivative litigation and legal actions brought by a company against its CEO. For example, on February 26, 2004, the Delaware Chancery Court blocked the then CEO, Conrad Black, from selling his controlling interest in the

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newspaper company Hollinger International to the Barclay brothers of Britain ruling that the independent directors of the company had a right to ﬁrst try and sell the company’s assets at a more favorable price to better serve the shareholders’ interests (Hollinger International, Inc. v. Conrad M. Black, 2004). Black had developed a sale agreement with the Barclays that would have enriched him personally, beneﬁted other members of top management, and proﬁted other Black-owned-interests at the expense of Hollinger International. Framing question: What information exists about management activities and the control environment that might raise a red ﬂag with respect to the accuracy and reliability of the ﬁnancial statements? Do related party disclosures adequately describe the relationship of the parties and the effects of the transactions on the ﬁnancial statements?5 Have these transactions been adequately reviewed and commented upon in the notes? Do Form 8-K ﬁlings with the SEC provide any information that might bring into question the validity of ﬁnancial information?

Building Shareholder Trust: Financial Statements that ‘‘Present Fairly’’ The controller oversees the internal development and preparation of ﬁnancial statements and she reports to the CFO. The ﬁnancial statements should be prepared in accordance with GAAP. The external auditor renders an opinion whether the statements ‘‘present fairly’’ the ﬁnancial position, results of operations, and changes in cash ﬂows in accordance with these principles. While it is well known that the general acceptance of accounting principles is linked to the process of establishing those principles and that the Financial Accounting Standards Board (FASB) is the current standardsetting body, it is less clear what is meant by the term ‘‘present fairly.’’ If the ﬁnancial statements are not fairly presented, then the stockholders will not be able to rely on the statements for their decision making. The term ‘‘fairly’’ implies the objective determination of which principles should be used to most accurately reﬂect the underlying events and transactions that make up ﬁnancial statement information. In accounting we refer to this notion as ‘‘representational faithfulness.’’ It is an ethical process that relies on the choice of estimates and judgments that accurately, consistently, and reliably record and report transparent ﬁnancial information. The process depends on the control environment as will be discussed in the next section.

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Statement of Financial Accounting Concepts No. 2, Qualitative Characteristics of Accounting Information (FASB, 1980), deﬁnes representational faithfulness as the correspondence or agreement between a measure or description and the phenomenon it purports to represent. The phenomenon refers to the economic resources and obligations and the transactions and events that change those resources and obligations. Copeland (2005, p. 37) identiﬁes several factors that have caused the public to question the ethics of accountants and auditors including when corporate accountants and auditors work together to shape transactions for a desired accounting treatment even when the economic substance of the transaction would be more accurately reﬂected using a different approach. He notes that while these treatments may be in accordance with GAAP, they often did not ‘‘present fairly’’ the underlying economic realty. Copeland notes that in these instances, accountants and auditors failed to live up to their responsibilities to the investing public. Framing question: What factors drive the estimates and judgments made by management? Are there internal factors that inﬂuence how ﬁnancial measurements are made and disclosed? How do these relate to the virtues? Are there internal factors that inﬂuence in what period(s) revenues and expenses are recorded? How do these relate to the virtues? What motivates management in its choice of accounting principles? Have these choices been adequately vetted by the external auditors and audit committee? How does the company deal with the information asymmetry problem? Is there adequate disclosure of the estimates and judgments? Is there adequate disclosure of the risks and uncertainties inherent in the process and resulting ﬁnancial statement amounts?

Ethical Values: The Control Environment The integrity of the ﬁnancial reporting process depends on the underlying ethical values inherent in an organization. The COSO Report (COSO, 1994) points out that ‘‘Integrity must be accompanied by ethical values, and must start with the chief executive and senior management and permeate the organization.’’ COSO notes that internal control systems cannot rise above the integrity and ethical values of the people who create, administer, and monitor them. For example, the controls at Enron included an approval

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form to establish off-balance-sheet entities yet the CEO at that time, Jeff Skilling, failed to sign it. The entities were created even though Skilling did not sign on the form because Enron had established a culture that enabled items to be fast-tracked, regardless of the needed approvals, if it was an essential part of the company’s efforts to manage earnings to meet ﬁnancial analysts’ expectations. The control environment of an organization should mitigate the risk of fraud by having mechanisms in place to counterbalance any incentives or pressures to commit fraud and by establishing an ethical tone that makes it clear to all in the organization that unethical conduct will not be tolerated. To achieve this goal, the environment should be one that rewards those who exhibit virtues, such as the auditor virtues previously mentioned, and replaces those found not to demonstrate the acceptable level of virtue expected by the organization. The internal auditors play an important role and should be independent of any inﬂuence in the organization. They should have direct and unrestricted access to the audit committee (see Fig. 1). The internal auditors also should be involved in monitoring compliance with the code of conduct and the evaluation and improvement of governance processes. Section 404 obligates the external auditors to issue an independent assessment of management’s report on the internal controls and this obligation should include an evaluation of the internal audit process. Ramos (2004, p. 77) notes that while a company may point to its code of conduct as documenting its ethical values, ‘‘the mere existence of the documentation of a control is not sufﬁcient to support a conclusion about its operating effectiveness.’’ He suggests that what is needed is to evaluate the effectiveness of the code’s implementation. One way is to have ‘‘training sessions for management and employees on the company’s code and the establishment of formal channels for the conﬁdential communication of code violations to senior management.’’ To determine whether the code has been implemented effectively, Ramos identiﬁes four important questions to ask of top management. These can also serve as research questions in the control environment. 1. 2. 3. 4.

How is the code communicated? Do the entity’s employees and management follow the code? How is compliance with the code monitored? Does compliance with the code improve the effectiveness of other control policies and procedures?

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Castellano and Lightle (2005) call for a ‘‘cultural audit’’ as a way to ‘‘provide a means for assessing the tone at the top and the attitude toward internal controls and ethical decision-making.’’ The authors identify three speciﬁc questions to be asked in a cultural audit including the following: 1. The degree to which preoccupation with meeting the analysts’ expectations permeates organizational climate. 2. The degree of fear and pressure associated with meeting numerical goals and targets. 3. The compensation and incentive plans that may encourage unacceptable, unethical, and illegal forms of earnings management. Castellano and Lightle (2005, p. 10) suggest that surveys of large numbers of employees at all levels within a company can help to identify the key issues affecting tone, cultural, and internal control risk assessment. If meeting ﬁnancial analysts’ expectations is uppermost in the minds of top management, then an effective cultural audit should help to assess whether and to what extent this preoccupation inﬂuences the company’s day-to-day operations and creates a culture of fear. Framing question: Does the framework used to evaluate internal controls capture management’s philosophy and operating style? How does management view internal controls? Are controls viewed as a necessary evil or as an integral part of the company’s management? Does management strictly adhere to its own controls or periodically override controls when it serves their self-interests? Are employees involved in the assessment of internal controls? Do employees receive periodic training to enhance ethics compliance? What mechanisms exist in the organization to provide an anonymous outlet for employees to express their concerns? How are employees evaluated with respect to the conformity of their behavior to provisions in the code of conduct? Is there consistency between ethics and compliance policies and actual organizational practices? How does the organization ensure that ethical standards are followed? How does the company deal with violations of its code of conduct? What role is played by the internal auditors in evaluating control processes? Do the internal auditors provide a check on the actions by top management to ensure compliance with policies and code provisions?

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Do the internal auditors provide objective assurance to the audit committee on corporate governance?

ETHICAL ORGANIZATION ENVIRONMENT: OUR ROLE AS EDUCATORS Copeland (2005) believes that part of the role of a university professor is to inﬂuence the ethical behavior of students. This belief is a controversial issue as evidenced by the recent negative reaction of many accounting academics to the proposal in Rule 5-1 and Rule 5-2 offered by the National Association of State Boards of Accountancy (NASBA, 2005a, b) to require separate courses in ethics as a condition of qualifying for the Certiﬁed Public Accountants (CPA) Examination. NASBA has withdrawn its proposal because of strong opposition. Still, Texas has become the ﬁrst state to require an ethics course for all accounting students. The issue is not likely to go away, and it should not, because accounting educators are training future accountants and auditors who will be responsible for developing, monitoring, and reporting on whether an organization has an ethical control environment. Copeland (2005, pp. 41–43) emphasizes the importance of leadership to ethics. He points out that students and audit staff want to know what the leaders value; not what they say their values are but whether they behave because of these values. Copeland notes that students and junior auditors will make decisions based on how they perceive these values. He suggests that accounting educators should set high standards for ethical conduct in and out of the classroom (setting the right tone at the top) and be a good personal example for students (serving as a role model). Copeland’s remarks are relevant to the culture of an organization and the leaders that set the tone including top management, the board of directors, and audit committee. The employees want to know that their leaders ‘‘walk the talk of ethics.’’ Ethics policies and codes of ethics should not be just pieces of a paper to be ﬁled. Instead, they should be living documents that are periodically reviewed, discussed with employees, and used to guide ethical actions within the organization. Some educators might react to Copeland’s suggestions as crossing the line between being a technically competent teacher who communicates information accurately and effectively, something we all can agree on, and inﬂuencing the behavior of students. However, we inﬂuence the behavior of students in whatever we do and say even when we do or say nothing about

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ethics. When a teacher ignores ethics in the classroom she sends the message that ethics is not an important issue to discuss. But how can that be when strict codes of ethics exist for internal accountants, internal auditors, and external auditors? Moreover, the rules require auditors to evaluate the ethics of the organizations they audit, a big part of which is the conduct of accounting and auditing professionals within the organization.

FUTURE ISSUES AND CONCLUDING COMMENTS This chapter identiﬁes six areas of corporate governance that can serve as the basis for future ethics research. These include (1) Virtue Ethics: Role of the External Auditor; (2) Ethical Tone at the Top: Audit Committee Responsibilities; (3) Custodial Responsibilities: The Role of the Board of Directors; (4) Fiduciary Responsibilities: The Role of the CEO; (5) Building Shareholder Trust: Financial Statements that ‘‘Present Fairly; and (6) Ethical Values: The Control Environment. Examples are provided of how one group such as the audit committee can be used to develop framing questions for future research within each area. Researchers might extend the analysis in the chapter by using other groups within each of the six areas identiﬁed for future research. The conceptual framework presented in Fig. 2 describes how each element in a corporate governance system interrelates to other elements within the company (internal effect) and regulatory requirements outside the company (external effect). One way to strengthen research skills in these areas is to incorporate them into the accounting curriculum. As most accounting educators already know, the best way to learn about something is to teach it. The corporate governance systems described in this chapter might provide the basis for a capstone course in the accounting curriculum. The course could integrate ﬁnancial accounting issues such as estimates and judgments under accrual accounting that lead to earnings management with the role and responsibilities of corporate accountants and auditors in the control environment, and the oversight responsibilities of the audit committee in its relationship with the external auditors that should help to assure the fair presentation of the ﬁnancial statements. Researchers need to broaden their horizons to advance accounting ethics research. The issue of whether corporate governance systems operate in an ethical manner is a natural extension to earlier research that emphasized the culture of accounting ﬁrms and ethical reasoning. The reasoning process followed by the CEO and board of directors establishes the tone at the top

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of an organization. That tone should determine whether the internal control system will operate ethically and effectively to produce accurate, reliable, and transparent ﬁnancial information. The trustworthiness of ﬁnancial statement information depends on the integrity of the people who have a role in producing the statements. While most CEOs and CFOs undoubtedly try to do the right thing, the pressures that build up to meet internal goals and external forecasts can push an otherwise honest person over the edge. It is up to the control systems including the internal accounting and auditing functions anchored by an ethical organization environment to prevent another wave of accounting scandals.

NOTES 1. On April 16, 2004, the Securities and Exchange Commission (SEC) sanctioned Ernst & Young (EY) LLP because it was not independent in fact or appearance when it audited the ﬁnancial statements of PeopleSoft for ﬁscal years 1994–1999. The SEC found independence violations arising from EY’s business relationship with PeopleSoft that created a mutuality of interests resulting from EY’s Global Expatriate Management (EY/GEMS). The EY/GEMS in-house software program assisted clients with the tax consequences of managing employees with international assignments and was enhanced with the use of PeopleTools, a software product created by EY’s audit client, PeopleSoft. A business relationship was created whereby a license to use PeopleTools was granted to EY in return for a payment to the company of 15 percent of each licensee fee it received from outside customers purchasing the new software, 30 percent of each license renewal fee, and a minimum royalty of $300,000, payable in 12 quarterly payments of $25,000 each. The SEC found that EY and PeopleSoft had a ‘‘symbiotic relationship’’ engaging in joint sales and marketing efforts, sharing considerable proprietary and conﬁdential business information, and EY partnered with PeopleSoft to accomplish increased sales and boost consulting revenues for EY. 2. The experience of one former Big-Five CPA ﬁrm, (Arthur) Andersen, in the Waste Management case illustrates how client pressures can compromise integrity with the result being the failure of the auditor to prevent a company from issuing fraudulent ﬁnancial statements. On June 19, 2001, the SEC announced a $7 million settlement with the ﬁrm when three of its current or former partners knowingly or recklessly issued false and misleading unqualiﬁed audit reports on Waste Management’s ﬁnancial statements for the years 1993 through 1996. According to Accounting and Auditing Enforcement Release (AAER) No. 1405, the company had understated pre-tax earnings by $1.43 billion between 1992 and the three quarters ended September 30, 1997. Of this amount, $509 million was due to changes in depreciation expense of property and equipment. Andersen knew about the problem but let it go in return for a promise by the ofﬁcers of Waste Management to ‘‘clean up its act,’’ – a promise never fulﬁlled.

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3. In the case of Hollinger International, a variety of transactions related to the sale of newspaper interests included non-compete payments to top company ofﬁcials that were not asked for by the buying entity but required by the seller to sell the assets. These amounts went directly to the ofﬁcers or were routed to interests outside the company. For example, a $5 million non-compete amount was included in the sale to Horizon, a company owned and controlled by top ofﬁcials of Hollinger International. The payment was not disclosed to or approved by the independent directors or the audit committee. 4. Even though Richard Scrushy was acquitted of all charges in his involvement with the fraud at HealthSouth, the company settled with the SEC and agreed to pay a civil penalty of $100 million. Moreover, the former CFO, William T. Owens, pleaded guilty to his part in the fraud including certifying false ﬁnancial reports with the SEC. Owens testiﬁed for the government in its lawsuit against Scrushy and, ironically he was sentenced to ﬁve years in prison while Scrushy went free. 5. FASB Statement No. 57, Related Party Disclosures (FASB, 1982), establishes disclosure requirements for related party transactions in ﬁnancial statements. SAS No. 45, Omnibus Statement on Auditing Standards – 1983 (AICPA 1983) deﬁnes the procedures to be used by auditors to ensure that all material related party transactions that exist have been properly accounted for and disclosed.

REFERENCES American Accounting Association. (1986). Future accounting education: Preparing for the expanding profession (Bedford Report). American Accounting Association. American Institute of Certiﬁed Public Accountants (AICPA). (1983). Omnibus statement on auditing standards (SAS) No. 45. New York, NY: AICPA. American Institute of Certiﬁed Public Accountants (AICPA). (1990). Consideration of fraud in a financial statement audit. Statements on Auditing Standards (SAS) No. 99. New York, NY: AICPA. American Institute of Certiﬁed Public Accountants (AICPA). (2002). Consideration of internal control in a financial statement audit. Statements on Auditing Standards (SAS) No. 55. New York, NY: AICPA. Armstrong, M. B. (1987). Moral development and accounting education. Journal of Accounting Education, 3(Spring), 27–43. Bernardi, R. A. (2004). Suggestions for providing legitimacy for ethics research. Issues in Accounting Education, 19(1), 145–146. Castellano, J. F., & Lightle, S. S. (2005). Using cultural audits to assess tone at the top. The CPA Journal, 65(February), 6–11. Cohen, J., Krishnamoorthy, G., & Wright, A. (2004). The corporate governance mosaic and ﬁnancial reporting quality. Journal of Accounting Literature, 23, 125–148. Committee of Sponsoring Organizations of the Treadway Commission. (1994). Internal control – integrated framework (2 Vols.). American Institute of Certiﬁed Public Accountants. Copeland, J. E., Jr. (2005). Ethics as an imperative. Accounting Horizons, 19(1), 35–43. Financial Accounting Standards Board (FASB). (1980). Qualitative characteristics of accounting information. Statement of Financial Accounting Concepts (SFAC) No. 2. Norwalk, CT: FASB.

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Financial Accounting Standards Board (FASB). (1982). Related party disclosures. Norwalk, CT: FASB. Gaa, J. C. (1992). The auditor’s role: The philosophy and psychology of independence and objectivity. Proceedings of the 1992 Deloitte and Touche/University of Kansas symposium on auditing problems, University of Kansas, Lawrence, KS. Gaa, J. C., & Thorne, L. (2004). An introduction to the special issue on professionalism and ethics in accounting education. Issues in Accounting Education, 19(1), 1–6. Goergen, M., Manjon, M. C., & Renneboog, L. (2004). Recent developments in German corporate governance. ECGI – Finance Working Paper Series No. 41/2004. Gottlieb v. McKee, 107 A.2d 240 (1954). Hart, O. (1995). Firms, contracts, and financial structure. Cambridge, England: Oxford University Press. Hollinger International, Inc. v. Conrad M. Black, 844 A2d 1022 (Del Ch. 2004). Langenderfer, H. Q., & Rockness, J. W. (1989). Integrating ethics into the accounting curriculum: issues, problems, and solutions. Issues in Accounting Education, 4(Spring), 58–69. Libby, T. & Thorne, L. Virtuous auditors. CA Magazine, November 2003, http://www. camagazine.com/index.cfm/ci_id/18137/la_id/1.htm Loeb, S. E. (1988). Teaching accounting students ethics: some crucial issues. Issues in Accounting Education, 3(Fall), 316–329. Mintz, S. M. (1995). Virtue ethics and accounting education. Issues in Accounting Education, 10, 247–267. National Association of State Board’s of Accountancy (NASBA) (2005a). Rule 5-1, education requirements – deﬁnitions. http://www.nasba.org National Association of State Board’s of Accountancy (NASBA) (2005b). Rule 5-2 education requirements – determining compliance of the applicant’s education. http://www. nasba.org National Commission on Fraudulent Financial Reporting. (1987). Report of the national commission on fraudulent ﬁnancial reporting (Treadway Commission Report). http://www. coso.org/Publications/NCFFR.pdf Ponemon, L. A. (1992). Ethical reasoning and selection-socialization in accounting. Accounting, Organizations and Society, 17(3–4), 239–258. Ponemon, L. A., & Gabhart, D. R. L. (1990). Auditor independence judgments: A cognitive developmental model and experimental evidence. Contemporary Accounting Research, 7, 227–251. Ponemon, L. A., & Glazer, A. (1990). Accounting education and ethical development: The inﬂuence of liberal learning on students and alumni in accounting practice. Issues in Accounting Education, 5(1), 21–34. Ramos, M. (2004). Evaluate the control environment. Journal of Accountancy, 175(May), 75–81. Shaub, M. K. (1994). An analysis of the association of traditional demographic variables with moral reasoning of auditing students and auditors. Journal of Accounting Education, 12(1), 1–26. Shleifer, A., & Vishny, R. W. (1997). A survey of corporate governance. Journal of Finance, 52, 737–782. Thorne, L. (2003). The role of virtue on accountants’ ethical decision making. Research on Accounting Ethics, 4, 291–308.

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U.S. House of Representatives. H.R. 3763. (2002). http://www.news.ﬁndlaw.com/hdocs/docs/ gwbushsarbanesoxley072302.pdf Wyatt, A. R. (2004). Accounting professionalism: They just don’t get it! Accounting Horizons, 18(1), 45–53. Zeff, S. A. (2003). How the U.S. accounting profession got where it is today: Part II. Accounting Horizons, 17(4), 267–286.

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WILL CORPORATE GOVERNANCE AND WHISTLEBLOWING PROVISIONS IMPROVE FINANCIAL RESPONSIBILITY? Tara J. Shawver and Todd A. Shawver ABSTRACT Corporate governance is a current issue that needs to be addressed by all participants in a corporate environment; from the internal employees of the company, to the external vendors and auditors who provide products and services to the organization. This research seeks to examine corporate governance and whistleblowing characteristics of professional accountants using the Multidimensional Ethics Scale. Our results suggest that practicing accountants are unlikely to whistleblow for two earnings management situations.

INTRODUCTION Although there is no universal deﬁnition of corporate governance, Callahan, Dworkin, Fort, and Schipani (2002) suggest that corporate governance is the process that manages value creation and value transference relationships among various corporate claimants such as shareholders, employees,

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creditors, suppliers, and society at large. Good corporate governance provides accountability to these stakeholders and balances needs for efﬁciency and proﬁt with equitable treatment of corporate constituencies (Callahan et al., 2002). Vinten (1995) believes that with suitable corporate governance, whistleblowing would rarely be necessary; however, Vinten also notes that sound corporate governance has been sadly lacking and continues to be of concern despite attempts at reform. These feelings seem to resonate today, even after many well-known fraudulent ﬁnancial reporting scandals. Former chairman of the Securities and Exchange Commission (SEC), Richard Breeden, identiﬁes that a major concern is the inability of the audit profession to detect fraud and abuse, identifying that ‘‘in some sense, we have our focus backwards, to the extent you lay all the pressure and responsibility on the audit committee. Three or four individuals, no matter how much talent and time they are willing to bring to the job, are not going to match the internal and external audit functions’’ (Burns, 2004). Marshall and Heffes (2003) suggests that good corporate governance is not possible in companies where management does not want it, and ofﬁcers, insiders, auditors, and regulators are unwilling to intervene. Stephen Cooper, interim chief executive ofﬁcer (CEO) and chief restructuring ofﬁcer of Enron Corp., suggests that Sarbanes–Oxley is a helpful blueprint for reform, higher responsibility and accountability; however, ‘‘corporate governance is really a state of mind y whether it be pre-Sarbanes, during Sarbanes, or post-Sarbanes, the fact of the matter is, without the right state of mind, what we’re creating are just more hurdles for people who are committed to gaming the system to jump over. We are not ﬁxing the system’’ (Burns, 2004). Whistleblowing protections become more important where people are trying to override the internal controls or create fraudulent ﬁnancial statements. Many researchers have attempted to look back to possible inhibitors of good corporate governance as a result of many accounting scandals. We explore one corporate governance mechanism, whistleblowing, to determine whether practicing accountants are willing to whistleblow for two questionable situations of earnings management.

LITERATURE REVIEW Ethical Decision Making Rest (1986) proposes a four-stage model of the ethical decision-making process. The ﬁrst stage is moral issue recognition, followed by moral

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evaluation/judgment, moral intention, and moral behavior. The vividness of a moral dilemma may enhance the recognition of a moral issue (Jones, 1991). After recognition, individuals must make a moral evaluation or judgment. Moral evaluation leads to moral intention (Rest, 1986) and moral intention leads to moral behavior (Trevino, 1986). The model of ethical decision making is complicated as indicated by multiple variations of similar models. The literature related to ethical decision making is massive; there are three extensive reviews of the ethical decision-making literature (see Ford & Richardson, 1994; Loe, Farrell, & Mansﬁeld, 2000; O’Fallon & Butterﬁeld, 2005 for details). This study uses the Multidimensional Ethics Scale (MES) to evaluate ethical situations and extends prior literature by exploring whether there is a relationship between the MES and whistleblowing intentions of practicing accountants.

Whistleblowing Literature Whistleblowing is an act by an employee, former employee, or member of an organization to report illegal misconduct by an organization that will have adverse effects on the public interest. The public interests that are violated may be in the form of fraud, health, safety violations, and corruption (Lloyd-La Follette Act of 1912; United States Congress, 1912). Whistleblowers are those individuals who ‘‘sound an alarm from within the very organization in which they work, aiming to spotlight neglect or abuses that threaten the public interests’’ (Bok, 1980, p. 277). Alford (2001, p. 17) deﬁnes a whistleblower as ‘‘one who (1) acts to prevent harm to others, not to him or herself, (2) trying ﬁrst to rectify the situation within the framework provided by the organization, (3) while possessing evidence that would convince a reasonable person.’’ Whistleblowing policies and procedures are more well developed in the healthcare and engineering industries due to a direct impact on public safety. Whistleblowing has impacted policy changes in the engineering industry over the anti-nuclear movement (Bernstein & Jasper, 1996; Nelkin, 1971; Jasper, 1990). Ahern and McDonald (2002) studied motivational factors to attempt to explain why some registered nurses report misconduct while others do not. Those who chose to whistleblow indicated beliefs that nurses are primarily responsible to protect the health of the patient while non-whistleblowers believe that nurses have an obligation to follow a physician’s orders at all times while balancing responsibilities to the patient, the physician, and their employer.

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Although there is no theory related to whistleblowing speciﬁcally, Miceli and Near (1985) have suggested expectancy theory (Vroom, 1964) as why one may choose to whistleblow. Expectancy theory views motivation in light of the consequences of one’s decision to whistleblow including desires to have management correct the wrongdoing once the action has been reported or actions against the whistleblower subsequent to whistleblowing (i.e., retaliation). Near and Miceli (1995) propose a model linking perceived motives to the termination of wrongdoing. Factors inﬂuencing cessation of wrongdoing include characteristics of the whistleblower, complaint recipient, the wrongdoer, the wrongdoing, and the organization (Miceli & Near, 1995). Research suggests that whistleblowers are likely to be committed and valued members of the organization who feel compelled to report wrongdoing, believe they are doing their jobs as the organization has prescribed them (Miceli, Near, & Schwenk, 1991), and people with higher levels of moral reasoning are more likely to whistleblow (Brabeck, 1984). Situational factors affect whistleblowing intentions; whistleblowing is more likely for behaviors of mismanagement, sexual harassment, and legal violations and less likely for stealing, waste, discrimination, and safety problems (Near et al., 2004). Organizational factors may contribute to whistleblowing intentions; written policies are associated positive perceptions about the encouragement of whistleblowing (Keenan, 1990) and external whistleblowing is signiﬁcantly related to supervisor support and informal company policies (Sims & Keenan, 1998). Power theory suggests the extent a whistleblower will be able to change behaviors at their organization depends on the power they have (Near & Miceli, 1987); in most cases the individual depends on the organization more than the organization depends on the individual (Pfeffer & Salancik, 1978); which may explain why so few people report wrongdoing (Miceli & Near, 1992). A detailed discussion of various power theories including resource dependence, value congruence, minority inﬂuence in groups, and individual power bases can be found in Near and Miceli (1995). Further, a fear of retaliation may inhibit whistleblowing intentions (Keenan, 2002). Social psychologists Latane and Darley (1970) explored a phenomenon called ‘‘diffusion of responsibility’’ which is also called bystander theory or bystander apathy. Experiments show that as the number of bystanders increases, the likelihood that a person would help or respond to someone in distress decreases. A possible explanation is that each bystander assumes someone else would help those in need. Grandossy and Sonnenfeld (2005)

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suggest that many ﬁnancially literate executives endorsed or ignored what they knew was ethically and professionally wrong and that ‘‘they discarded their own sense of responsibility, deceiving themselves into believing that other fellow experts who allowed the misconduct knew better than they did about what was right. This diffusion of responsibility demonstrated a collective bystander apathy exacerbated by obedience to top leaders responsible for initiating the fraudulent schemes’’ (Grandossy & Sonnenfeld, 2005, p. 232). Further, Samuelson and Gentile (2005) suggest that bystanders do not act on their values because they do not consider it to be a part of their jobs. This chapter attempts to determine the reasons accountants may use to justify whistleblowing for two situations of earnings management. The literature provides several varying deﬁnitions of earnings management. ‘‘Accounting earnings management includes the interpretation of accounting standards and their application to transactions and events that have already occurred. Essentially, the manager shifts some amount of earnings from one period to the other’’ (Ewert & Wagenhofer, 2005, p. 1104). According to Healy and Wahlen (1999), earnings management occurs when managers use the ﬁnancial reporting process to manipulate earnings to alter ﬁnancial reports either to mislead key stakeholders in the true ﬁnancial performance of the organization, or to inﬂuence contractual outcomes that depend on reported accounting numbers. McKee (2005) provides deﬁnitions of earnings management and fraud differentiating between legal and illegal activities. ‘‘Earnings management may be deﬁned as reasonable and legal management decision making and reporting intended to achieve stable and predictable ﬁnancial results. Earnings management is not to be confused with illegal activities to manipulate ﬁnancial statements and report results that do not reﬂect economic reality. These types of activities, popularly known as ‘cooking the books’, involve misrepresenting ﬁnancial results’’ (McKee, 2005, p. 1). Further, fraud is ‘‘the intentional, deliberate, misstatement or omission of material facts, or accounting data, which is misleading and, when considered with all the information made available, would cause the reader to change or alter his or her judgment or decision’’ (McKee, 2005, p. 43). If an accountant is aware of questionable earnings management, should one whistleblow? Both the American Institute of Certiﬁed Public Accountants (AICPA) and the Institute of Management Accountants (IMA) specify that accountants have a duty to maintain client conﬁdentiality. Collins and Schultz (1995) discuss how maintaining client conﬁdentiality when detrimental practices occur can harm public interests; further a detailed

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discussion is provided regarding a Certiﬁed Public Accountant’s (CPA) responsibility to the public over their responsibility to the client. Many ﬁrms may prefer to deal with unethical or illegal acts internally since whistleblowers may threaten the organization’s authority structure and public image (Weinstein, 1979). Barnett, Cochran, and Taylor (1993) found advantages to organizations when internal whistleblowing is encouraged, appropriate changes are made, and external whistleblowing is prevented. Barnett et al. (1993) suggest procedures for the development of internal disclosure policies, communication channels, investigative procedures, and protection vehicles for the whistleblower in order to discourage external whistleblowing. Researchers suggest many factors that reduce external whistleblowing, including having a code of ethics and including ethics in the corporate philosophy (Winﬁeld, 1990), having clear guidelines on unacceptable behavior and clear procedures for internal reporting (Winﬁeld, 1994), and having whistleblower protections (Benson & Ross, 1998). Vinten (2003) also agrees that internal whistleblowing can be effective when it is accepted as a part of the organizational culture, and that external whistleblowing is far less desirable causing expensive consequences for both the organization and the whistleblower. In some limited circumstances, accountants are encouraged to report illegal activities to external agencies; SEC Rule 10A requires external auditors to report illegal activities to both the board of directors and the SEC. However, recent frauds have caused a public outcry for more standards to protect public interests. The Sarbanes– Oxley Act provides protection for accountants working at public companies who chose to report wrongdoing; however, the protection for accountants working for private companies is not as deﬁnitive.

Whistleblowing Studies in Accounting There are only a handful of studies in the accounting context related to whistleblowing intentions. Spencer (1987) views whistleblowing for an internal auditor as being an ever-present possibility describing common examples of audit managers ﬁltering out ﬁndings from audit reports with little or no explanation. In less material situations the auditor may give grudging assent. However, if signiﬁcant but not life threatening, illegal, or immoral, many auditors would choose to leave the company but not whistleblow. Some auditors would choose to report to regulatory authorities outside the chain of command for serious situations, such as lifethreatening, felonious, or abhorrent violations of moral principles.

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Near and Miceli (1988) found that 80% of directors of internal audit had observed wrongdoing in the preceding year and 90% of these directors had reported the wrongdoing. Of those that chose to whistleblow, only 6% suffered retaliation for whistleblowing. Very few of these directors felt that whistleblowing should be done externally. Even with 25% choosing to whistleblow externally, it was generally to the external audit team only. These ﬁndings agree with similar views that whistleblowing should be an exceptional event, although internal auditors experience wrongdoing as a regular part of their work. Further, directors of internal audit are more likely to report wrongdoing if they consider themselves high performers, work in organizations with low bureaucracy, and felt prescribed by their role or morality to report wrongdoing (Miceli et al., 1989). Arnold and Ponemon (1991) found internal auditors are much less likely to whistleblow than external auditors. Label and Miethe (1999) found that most auditors preferred internal disclosure of a wrongdoing rather than external whistleblowing (75 and 25%, respectively) and most auditors strongly opposed legislation that required whistleblowing. Chung, Monroe, and Thorne (2004) also found that auditors are more likely to blow the whistle internally than externally, more likely to whistleblow where the organizational climate is principle based as opposed to rule based, and more likely to blow the whistle on a less powerful wrongdoer. Xu and Ziegenfuss (2003) found that internal auditors are more likely to blow the whistle for a reward (i.e., cash or a continuing employment contract), and those internal auditors with lower levels of moral reasoning are more sensitive to cash rewards than internal auditors with higher levels of moral reasoning. Further, Lovell (2002) identiﬁes that in a study of accountants and human resource professionals, those who are aware of unethical and illegal acts expressed grave concerns for their current and future employment prospects if they were to voice their concerns either internally or externally. There are no known studies that question what values may impact the decision to whistleblow for practicing accountants. Often a whistleblower is faced with conﬂicting values that may involve rights of the public, individuals, and the rights of the corporation.

Multidimensional Ethics Scale The MES, initially developed by Reidenbach and Robin (1988), is used to identify the respondents’ values and beliefs related to ethical theories of justice, deontology, utilitarianism, relativism, and egoism. In addition, a

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compassion dimension has been added as a result of debates over possible gender differences in ethical decision making. Although each philosophy is brieﬂy described in this section, we acknowledge that there is an abundance of literature and philosophers for each of these ethical theories. We explore the respondents’ values, beliefs, and obligations in relation to their ethical evaluation and their likelihood to blow the whistle for two earnings management vignettes written by Cohen, Pant, and Sharp (1993, 1998). The philosophical theories relating to justice are derived from Aristotle. Recently, John Rawls (1971) has done a signiﬁcant amount of work related to the theories of justice outlining justice as a fair set of rules for society. Ethical relativism suggests that moral rightness and wrongness of actions varies from society to society and that there are no absolute universal moral standards binding on all men at all times; what is right in one society may be wrong or neither right nor wrong in another society (Ladd, 1973). Further, ‘‘cultural relativism maintains that there is an irreducible diversity among cultures because each culture is a unique whole with parts so intertwined that none of them can be understood or evaluated without reference to the other parts and to the cultural whole’’ (Ladd, 1973, p. 2). Egoistic actions are often chosen to beneﬁt an individual’s interests (Sidgwick, 1874); in comparison, utilitarian actions are done for the greatest good. It is assumed that an action is right if there is no other action or alternative that would produce more good than the action chosen. Utilitarianism allows for more ﬂexibility in decision making. Even if an action is morally wrong, it could still be the best possible choice if there is the least amount of harm to another involved with the decision. For detailed discussions of utilitarianism see the works of John Stuart Mills (1961). Deontological choices focus on the principles of right and wrong including unwritten or implied contracts, such as those found in the use of generally accepted accounting principles (GAAP). For discussions related to deontology see the work of Immanuel Kant (1980). Recently, ‘‘deontological moralists have claimed that an action is right only if it is accord with the correct moral rules, and wrong only if it violates those rules. According to the deontological position, one should follow the moral rules in all cases, and disregard the fact that such action may lead to bad consequences. This position seems to allow no exceptions to moral rules’’ (Brody, 1970, p. 3). A question is used to measure compassion, a concern for caring, that has been suggested as a feminine perspective of ethical evaluations (Gilligan, 1982). Alford (2001, p. 95) suggests that ‘‘morality stems from empathy, in which we are deeply affected by the sufferings of others.’’ Prior studies using the MES conducted by Shawver, Sennetti, and Bancroft (2006); Shawver and Clements (2007); Sennetti,

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Shawver, and Bancroft (2004); Cohen et al. (1993, 1996, 1998); Cruz, Shafer, and Strawser (2000); and Reidenbach and Robin (1990) found that many of these philosophical views inﬂuence decisions described in studies using their respective situational vignettes. Therefore, we accept these philosophical views and hypothesize the following: H1. Professional accountants identify philosophical views of justice, deontology, utilitarianism, relativism, egoism, and compassion as reasons that earnings management actions are unethical. Shawver and Clements (2007) examined whistleblowing intentions of accounting students using four of the accounting and business vignettes developed by Cohen et al. (1993, 1998). Two of the earnings management vignettes are used in this study. Shawver and Clements found that accounting students identiﬁed justice in vignettes Early Shipment and Bad Debt as a reason to whistleblow; in addition, utilitarianism was marginally signiﬁcant as a reason to whistleblow in vignette Early Shipment. Since prior research does not examine the whistleblowing intentions of practicing accountants using the MES, we explore whether these philosophical constructs are signiﬁcant in the decision to whistleblow; therefore, we hypothesize the following: H2. Professional accountants will identify philosophical views of justice, deontology, utilitarianism, relativism, egoism, and compassion as reasons for whistleblowing.

METHODOLOGY In December 2004, during a CPE session of 93 practicing accountants, we requested that the participants complete an anonymous survey. Fifty-seven participants agreed to complete the survey. Forty-two usable responses were obtained after incomplete surveys were eliminated from the study. The average age of these practicing accountants is 49 years with 22 years of experience and included 36 males and 6 females. Thirty-seven out of the 42 respondents (88%) are CPAs. A majority of the respondents work for private companies and have identiﬁed their position as an accountant or a member of management. Further details of the demographics of the respondents are provided in Table 1. Prior to the commencement of the survey, respondents were supplied the following deﬁnition of whistleblowing: an act by an employee, former employee, or member of an organization to report illegal misconduct by an organization that will have adverse effects

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Table 1. N

Percentage

Gender Male Female Blank Total

36 6 0 42

86 14 0 100

Age (years) 19–29 30–39 40–49 50–59 Above 60 Blank Total

2 7 13 11 9 0 42

5 17 31 26 21 0 100

Experience (years) 0–9 10–19 20–29 Above 30 Blank Total Political view Very liberal Somewhat liberal Neither Somewhat conservative Very conservative Blank Total

Demographics. N

Percentage

Job type Management Accountant Auditor Consultant Total

14 20 7 1 42

33 48 17 2 100

Certiﬁcation CPA None indicated Total

37 5 42

88 12 100

4 1 1 12 19

10 2 2 29 45

5 42

12 100

2 33

5 79

6

14

1

2

42

100

Size of company (assets) 6 14 14 8 0

14 33 33 19 0

42

100

0 15

0 36

11

26

15

36

0

0

1 42

2 100

Up to $250,000 $250,000–1 million $1–$2 million Over $2 million Provide work for more than one Blank Total Company types Public Private Provide work for both Blank Total

on the public interest. The public interests that are violated may be in the form of fraud, health, safety violations, and corruption (Lloyd-La Follette Act of 1912). Each respondent was asked to complete the anonymous survey and was informed that their participation is voluntary. Each questionnaire

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was administered during the CPE session (at the end of the session) with instructions on how to complete each section. Two earnings management scenarios, written, validated, and used in prior studies by Cohen et al. (1993, 1998) are provided in the appendix. Vignette Early Shipment discusses the early shipment of product to meet a quarterly bonus and vignette Bad Debt discusses a situation where a controller adjusts a company’s bad debt estimate to increase reported income. Either directly or indirectly, both of these vignettes would have an impact on net income reported on the ﬁnancial statements and could be used to manipulate earnings to shift income from one period to the next. Each respondent evaluates each action using the questions of the MES; further each respondent indicates their belief of whether the action was ethical and whether they would complete various actions on a 7-point Likert scale reported in Table 2. Finally, an open-ended question allows the participant to provide additional feedback of why they would or would not whistleblow for each vignette. Prior researchers (Reidenbach & Robin, 1990; Cohen et al., 1998) used exploratory factor analysis with varimax rotation grouping the MES questions into factors. This study uses the same procedures of exploratory factor analysis. Reidenbach and Robin (1990) identiﬁes that each philosophy has its own ‘‘unique conceptual core;’’ however, there is a conceptual overlap between the philosophies. Since ethical decision making is often complicated, individuals may use more than one rationale in making ethical judgments and may not view each philosophy as independent of another. A factor analysis will group the questions into ‘‘buckets’’ based on the evaluations of the respondents and how they evaluated each ethical dilemma. Initial exploration of the reliability of each factor suggests the removal of the question relating to self-promoting actions would signiﬁcantly improve the reliability of the ﬁrst factor for both vignettes. Further, the fourth factor in each vignette is removed from the initial analysis since it contains only

Table 2. Vignette Is it ethical Would you do it Peers do it Whistleblow

Means and Standard Deviations. Early Shipment 5.71 5.88 4.57 4.14

(1.43) (1.40) (1.56) (1.76)

Bad Debt 5.79 5.74 4.57 3.85

(1.32) (1.33) (1.61) (1.77)

Note: (1 As ethical, 7 as unethical); (1 complete the act, 7 would not complete the act); (1 whistleblow, 7 would not whistleblow).

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one question. A review of the Kaiser-Meyer-Olkin (KMO) measure of sampling adequacy ranges from 0 to 1; KMO scores in this study are 0.686 for Early Shipment and 0.771 for Bad Debt indicating that our sample size, although small, is adequate to continue with factor analysis. We continue with modiﬁed factors and report the factor structures for the Early Shipment vignette in Table 3 and the factor structure for the Bad Debt vignette in Table 4. For the Early Shipment vignette the ﬁrst factor includes the responses to whether the action is believed to be just/unjust, fair/unfair, or morally right/ not morally right; which have been used in prior studies to measure attitudes related to justice. In addition, the ﬁrst factor includes one deontology question of does not violate an unwritten contract/violates a written contract, one utilitarianism question including produces maximum utility/ produces least utility, and the compassion question of shows compassion or caring/shows no compassion or caring. This factor structure includes the broad-based ideas of moral equity and based on the factor loadings, the respondents identiﬁed that contracts with society, utility, and compassion are similar to many of the justice dimensions. This factor appears to be

Table 3. Early Shipment Rotated Component Matrix. Principal Component Analysis with Varimax Rotation. Questions

Just/unjust Fair/unfair Morally right/not morally right Acceptable to family/not acceptable to family Culturally acceptable/not culturally acceptable Traditionally acceptable/not traditionally acceptable Satisfying for the actor/not satisfying for the actor Produces the greatest utility/produces least utility Violates an unwritten contract/does not violate a contract Violates an unspoken promise/does not violate an unspoken promise Shows compassion of caring/shows no compassion of caring Factor alphas KMO Total variance explained

Factors 1

2

3

0.913* 0.926* 0.845* 0.153 0.311 0.114 0.050 0.593* 0.659* 0.340

0.084 0.063 0.036 0.745* 0.000 0.795* 0.196 0.168 0.489 0.776*

0.184 0.169 0.161 0.255 0.822* 0.102 0.787* 0.083 0.067 0.116

0.781*

0.023

0.284

0.882 0.686 0.702

0.643

0.597

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Table 4.

135

Bad Debt Adjustment Rotated Component Matrix. Principal Component Analysis with Varimax Rotation Factors.

Questions

Just/unjust Fair/unfair Morally right/not morally right Acceptable to family/not acceptable to family Culturally acceptable/not culturally acceptable Traditionally acceptable/not traditionally acceptable Produces the greatest utility Minimizes beneﬁts/maximizes beneﬁts Violates an unwritten contract/does not violate a contract Violates an unspoken promise/does not violate an unspoken promise Shows compassion of caring/shows no compassion of caring Factor alphas KMO Total variance explained

Factors 1

2

3

0.886* 0.887* 0.875* 0.170 0.180 0.013 0.363 0.079 0.650* 0.418

0.228 0.053 0.098 0.651* 0.225 0.753* 0.040 0.846* 0.100 0.675*

0.182 0.262 0.082 0.323 0.807* 0.336 0.740* 0.031 0.188 0.237

0.602* 0.867 0.771 0.701

0.362 0.759

0.423 0.660

business oriented, in that decisions are not only based on what is just, right, or moral but decisions also include what is best for the business in a utility and contractual sense. Reidenbach and Robin (1990) identiﬁes that often business involves quid pro quo wherein one person provides a product or service in exchange for something of value. A broadened view of business extends to ethics and may include ideas of duty, rights, and fair play (Reidenbach & Robin, 1990). The second factor for the Early Shipment vignette includes two questions generally used to measure relativism; responses to the questions acceptable to my family/not acceptable to my family and traditionally acceptable/ traditionally unacceptable and one deontology question of violates an unspoken promise/does not violate an unspoken promise. The second factor appears to be more personally motivated. The inclusion of the second deontology question of violating a promise suggests the respondents may view that when a promise is made these agreements are related to actions of the family or tradition in one’s background. The third factor includes culturally acceptable/not culturally acceptable and satisfying for the actor/not satisfying for the actor. The third factor also appears to be personally motivated by satisfaction and one’s satisfaction may be based on cultural norms.

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The ﬁrst factor in the Bad Debt vignette is similar to the ﬁrst factor in the Early Shipment vignette and includes the following questions: just/unjust, fair/ unfair, morally right/not morally right, does not violate an unwritten contract/ violates a written contract, and shows compassion or caring/shows no compassion or caring. The second factor is one of a personal nature and is similar to the second factor in our ﬁrst vignette. The second factor includes responses to the questions acceptable to my family/not acceptable to my family, traditionally acceptable/traditionally unacceptable, minimizes beneﬁts/ maximizes beneﬁts, and violates an unspoken promise/does not violate an unspoken promise. As previously discussed, the inclusion of the second deontology question of violating a promise or minimizing harm to others has some implications that actions may be related to views of the family and tradition from one’s background. The third factor includes culturally acceptable/not culturally acceptable and produces the greatest utility/produces the least utility. The third factor also appears to be personally motivated by relativistic views of utility that often can be based on cultural norms. Table 5 provides the Pearson correlations for each factor and their correlations to the dependent variables of ‘‘is it ethical’’ and ‘‘would you

Table 5. Early Shipment Pearson Correlations. Ethical Evaluations, Whistleblowing, and MES Factors.

Pearson correlation

Signiﬁcance (one-tailed)

V1 Ethical V1F1 V1F2 V1F3 V1 Ethical V1F1 V1F2 V1F3

V1 Ethical

V1F1

V1F2

V1F3

1.000 0.728 0.225 0.324

1.000 0.346 0.239

1.000 0.220

1.000

0.000 0.076 0.018

. 0.012 0.064

. 0.081

V1F1

V1F2

V1F3

1.000 0.392 0.219 0.120

1.000 0.346 0.239

1.000 0.220

1.000

0.005 0.081 0.225

. 0.012 0.064

. 0.081

V1 Whistleblow Pearson correlation

Signiﬁcance (one-tailed)

V1 Whistleblow V1F1 V1F2 V1F3 V1 Whistleblow V1F1 V1F2 V1F3

.

.

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Table 6. Debt Adjustment Pearson Correlations Ethical Evaluations, Whistleblowing, and MES Factors. V2 Ethical Pearson correlation

Signiﬁcance (one-tailed)

Pearson correlation

Signiﬁcance (one-tailed)

V2 Ethical V2F1 V2F2 V2F3 V2 Ethical V2F1 V2F2 V2F3

V2 Whistleblow V2F1 V2F2 V2F3 V2 Whistleblow V2F1 V2F2 V2F3

V2F1

V2F2

V2F3

1.000

1.000 0.821 0.459 0.493 . 0.000 0.001 0.000

1.000 0.435 0.539

1.000 0.363

. 0.002 0.000

. 0.009

V2 Whistleblow

V2F1

V2F2

V2F3

1.000 0.450 0.422 0.276

1.000 0.436 0.547

1.000 0.332

1.000

0.002 0.003 0.040

. 0.002 0.000

. 0.017

.

.

whistleblow’’ for vignette Early Shipment. Table 6 provides the Pearson correlations for each factor and their correlations to the dependent variables of ‘‘is it ethical’’ and ‘‘would you whistleblow’’ for the Bad Debt vignette. These tables show that some of the factors and the ethical evaluations are correlated. This result is not surprising since prior researchers have identiﬁed that ethical judgment is ‘‘comprised of a number of overlapping theoretical dimensions which are inherent in the different philosophies y essentially, our notions of justice, fairness, morality, and what is acceptable to our families are, in large part, tradition and culture based. Notions of moral equity are tempered by an experiential and social process bounded by our traditions and culture. Tradition and culture shape our beliefs, values, and attitudes in all aspects of life and certainly inﬂuence our notions of what is right and wrong’’ (Reidenbach & Robin, 1990, p. 646). Variance Inﬂation Factors (VIFs) are reported for each regression model to identify possible multicolinearity problems. All VIFs are below 1.564; which is well below a benchmark of 10 suggested by Myers (1990).

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RESULTS AND DISCUSSION In Table 2, we summarize the means and standard deviations for the evaluation of each ethical situation, ethical intention, and the likelihood that practicing accountants will whistleblow. The means indicate that these accountants believe both acts are unethical with a mean for vignette Early Shipment of 5.71 (standard deviation 1.43) and a mean of 5.79 (standard deviation 1.32) for vignette Bad Debt on a scale from 1 to 7 (1 as ethical and 7 as unethical). The means for ‘‘the probability that I would undertake the same action’’ with a mean for vignette Early Shipment of 5.88 (standard deviation 1.4) and a mean of 5.74 (standard deviation 1.33) for vignette Bad Debt (1 complete the act, 7 would not complete the act) indicating an intention not to complete these unethical acts. However, the responses to both vignettes to the likelihood that their peers would complete the act are closer to the mid range with a mean for both vignettes of 4.57 indicating an intention not to complete these unethical acts. The means for ‘‘the probability that I would whistleblow’’ with a mean for vignette Early Shipment of 4.14 (standard deviation 1.76) and a mean of 3.85 (standard deviation 1.77) for vignette Bad Debt (1 whistleblow, 7 would not whistleblow) indicating that although these practicing accountants realize both acts are unethical and they would not complete these acts, they are less likely to whistleblow. Table 7 presents several sets of paired sample t-tests conﬁrming that the participants in this study view the evaluations of ethicality of each vignette as statistically different than their evaluation of whether or not they would complete each action and further whether or not they would whistleblow for each action. These paired sample t-tests conﬁrm that the responses for each vignette are statistically different when comparing the means for the questions is it ethical, would you do it and would you whistleblow. Next, we consider why this group of accountants identiﬁed each action as unethical.

Table 7. Paired Samples Test. Vignette

Early Shipment Early Shipment Bad Debt Bad Debt

Paired Differences

Ethical – whistleblow Do it – whistleblow Ethical – whistleblow Do it – whistleblow

Mean (SD)

1.571 1.738 1.927 1.878

(2.55) (2.69) (2.61) (2.66)

Std. Error Mean

t-Value

Signiﬁcance (Two-Tailed)

0.393 0.415 0.406 0.415

3.996 4.191 4.742 4.526

0.000 0.000 0.000 0.000

Corporate Governance and Whistleblowing Provisions

Table 8.

Multiple Regression Results Early Shipment Vignette.

Dependent Variable

Shipment Factor 1 Shipment Factor 2 Shipment Factor 3 Model signiﬁcance Adjusted R2

139

Is it Ethical

Whistleblow

t-Value

Signiﬁcance

t-Value

Signiﬁcance

6.044 0.482 1.484

0.000** 0.632 0.146 0.000** 0.556

2.214 0.580 0.093

0.033** 0.565 0.926 0.079* 0.095

VIF

1.173 1.162 1.085

Note: The factors include the following questions: F1=just/unjust, fair/unfair, morally right/ not morally right, produces the greatest utility/produces least utility, violates an unwritten contract/does not violate a contract, shows compassion of caring/shows no compassion of caring; F2=acceptable to family/not acceptable to family, traditionally acceptable/not traditionally acceptable, violates an unspoken promise/does not violate an unspoken promise; F3=culturally acceptable/not culturally acceptable, satisfying for the actor/not satisfying for the actor. *Moderately signiﬁcant p-value o0.10; **Signiﬁcant p-value o0.05.

H1 Table 8 (ﬁrst three columns) presents the regression analysis between the evaluation of whether the action is ethical and the factors of the MES for the Early Shipment vignette and Table 9 presents the regression analysis for the Bad Debt vignette identifying why these practicing accountants feel the actions of earnings management are unethical. For vignettes Early Shipment and Bad Debt these practicing accountants have identiﬁed each action as unethical for reasons of justice, deontology, and compassion as shown in Factor 1 for both vignettes. In addition, these accountants also feel that utilitarianism is signiﬁcant suggesting that there is an evaluation of costs and beneﬁts when evaluating the Early Shipment vignette. The R2 for each vignette Early Shipment 0.556 and Bad Debt 0.664 shows signiﬁcant explanatory power in for the model for why these accountants have evaluated these earnings management actions as unethical. H1 is supported.

H2 For H2, a regression between the intention to whistleblow and the constructs of the MES identiﬁes that practicing accountants identify Factor 1 (justice,

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Table 9.

Multiple Regression Results Reduce Bad Debt Vignette.

Dependent Variable

Bad Debt Factor 1 Bad Debt Factor 2 Bad Debt Factor 3 Model signiﬁcance Adjusted R2

Is it Ethical

Whistleblow

t-Value

Signiﬁcance

t-Value

Signiﬁcance

6.582 1.155 0.461

0.000** 0.255 0.648 0.000** 0.664

1.818 1.703 0.030

0.077* 0.097 0.976 0.009** 0.207

VIF

1.591 1.254 1.449

Note: The factors include the following questions: F1=just/unjust, fair/unfair, morally right/ not morally right, violates an unwritten contract/does not violate a contract, shows compassion of caring/shows no compassion of caring; F2=acceptable to family/not acceptable to family, traditionally acceptable/not traditionally acceptable, minimizes beneﬁts/maximizes beneﬁts, violates an unspoken promise/does not violate an unspoken promise; F3=culturally acceptable/not culturally acceptable, produces the greatest utility/produces least utility. *Moderately signiﬁcant p-valueo0.10; **Signiﬁcant p-value o0.05.

deontology, compassion, and utilitarianism) as moderately signiﬁcant as a reason for whistleblowing in vignette Early Shipment (last three columns in Table 8). Factor 1 (justice, deontology, and compassion) in vignette Bad Debt is moderately signiﬁcant (last three columns in Table 9). The R2 for each vignette Early Shipment 0.095 and Bad Debt 0.207 shows some explanatory power for each model. H2 is supported. Prior research has not examined the underlying reasons of whistleblowing using the MES scale with practicing accountants; therefore, this study contributes to the body of whistleblowing literature. However, given these marginal ﬁndings additional exploration for the underlying reasons that may cause a practicing accountant to whistleblow are necessary; further discussion of additional factors future research may wish to consider will be discussed later. Table 10 reports frequency distributions to further explore the intentions of this sample to whistleblow. It becomes clear why the results are marginal for explaining intentions for this sample of accountants to whistleblow in situations of earnings management. For vignette Early Shipment only 33% indicate a likelihood to whistleblow for this unethical act and only 36% indicate a likelihood to whistleblow for vignette Bad Debt. Each respondent was asked whether they believe this situation would currently occur in practice; for both vignettes the average was 2.83 with a standard deviation of 1.75 indicating that it is more likely than not that these situations would

Corporate Governance and Whistleblowing Provisions

Table 10. Response

Frequency

141

Whistleblow Frequencies. Valid Percent

Cumulative Percent

Vignette Early Shipment – Likelihood to Whistleblow 1 3 7.1 2 8 19 3 3 7.1 4 8 19 5 8 19 6 10 23.8 7 2 4.8 Total 42 100

7.1 26.2 33.3 52.4 71.4 95.2 100

Vignette Bad Debt – Likelihood to Whistleblow 1 5 2 7 3 3 4 12 5 5 6 9 7 1 Total 42

11.9 28.6 35.7 64.3 76.2 97.6 100

11.9 16.7 7.1 28.6 11.9 21.4 2.4 100

occur in practice. Although both of these situations represent gray areas of earnings management, we expected that more accountants would have indicated a higher likelihood to whistleblow since their own ethical evaluations of these dilemmas indicated that these actions are unethical. Further, as result of exposure to the media and highly publicized impacts of many earnings scandals, including the loss of shareholder value, the demise of Arthur Andersen, and the loss of reputations of accountants and auditors may contribute to the likelihood of whistleblowing. Earnings management may be viewed by some accountants as ethical; however, such adjustments may lead to more aggressive adjustments in future periods. We asked each participant to provide any additional feedback that might provide insights of why one would or would not whistleblow by using an opened-ended question for each vignette. For vignette Early Shipment, responses indicate that most would not whistleblow because ‘‘it is not material,’’ ‘‘depends on circumstances or number of times transpired,’’ ‘‘if no harm to customer, let manager get his bonus, it will just reduce his sales for next quarter,’’ and the ‘‘manager himself would be hurt and may retaliate against me.’’ For the few that would whistleblow, responses indicate ‘‘this kind of behavior often leads to more expanded self-serving activity’’ and ‘‘it is not fair to other

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employees playing by the same rules.’’ For vignette Bad Debt, responses indicate that there is a lack of belief that it is the accountants’ responsibility to whistleblow hoping that ‘‘with good auditors this would be discussed and corrected by controller’’ and one would not whistleblow because the vignette involves an estimate rather than concrete numbers. For those few that would whistleblow they indicated a concern for investor harm and misleading or fraudulent ﬁnancial statements.

SUMMARY AND CONCLUSIONS This study indicates that although a sample of practicing accountants have identiﬁed two earnings management situations as unethical they are unlikely to whistleblow. These results are consistent with prior research indicating that most auditors strongly opposed legislation that required whistleblowing (Arnold & Ponemon, 1991; Label & Miethe, 1999) and those aware of unethical and illegal acts expressed grave concerns for their current and future employment prospects if they were to voice their concerns either internally or externally (Lovell, 2002). Most of the participants in this study work internally for private companies and would not be protected under Sarbanes–Oxley. This study provides some evidence that protections for those who work for private companies may be necessary to encourage whistleblowing. Felsburg (2005) discusses the various protections from retaliation under various circumstances for employees, including the Civil Rights Act of 1964, the Clean Air Act, the Americans with Disabilities Act, Fair Labor Standards Act, Occupational Safety and Health Act, Family and Medical Leave Act, and the National Labor Relations Act. However, there are no protections for reporting accounting manipulations at private companies. Accounting manipulations at private companies can have an effect on various stakeholders including creditors, suppliers, employees, and society; therefore, it seems that accountants and employees working for private ﬁrms should have similar protections. Miceli and Near (1995) found that over time perceived wrongdoing decreased and the frequency of whistleblowing increased after the passing of legislation to protect federal civil service employee whistleblowers. Further, a larger proportion of whistleblowers preferred to remain anonymous and those whistleblowers who were identiﬁed experienced retaliation (Miceli & Near, 1995). There are two added burdens of the Sarbanes–Oxley Act that set it apart from other statutes: the act holds individual executives, agents, and supervisors

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143

personally liable for retaliation; and it makes retaliation a felony offense. Sarbanes–Oxley requires the establishment of procedures for the conﬁdential and anonymous reporting of wrongdoing in a publicly traded company. Under the act, penalties for an executive who retaliates can include up to 10 years in prison. Sweeney (2005) suggests that employers should make it convenient for employees to report suspected incidents of misconduct, including dedicated hotlines with a toll-free number and the ability to accept collect calls when necessary. Whistleblowers should have access to a conﬁdential website, a fax number, and a regular mail address or post ofﬁce box. Although companies may make it more convenient for employees to whistleblow, there is still the fear that the act of whistleblowing comes with adverse consequences that could lead to the whistleblower’s professional demise. Companies should provide their employees with organizational policies and procedures for reporting unethical actions, federal guidelines on how employees are to deal with whistleblowing issues, or provide annual training sessions to employees with updates and reafﬁrmations of employee protections. Education is an important factor which will give employees the courage to take the appropriate actions and report illegal corporate wrongdoings. We need accountants and auditors with moral courage to come forward and identify wrongdoing before large collapses, such as Enron, occur again. Future researchers could explore whether protections granted under Sarbanes–Oxley has an impact on the decisions to whistleblow for accountants working at public companies and further if accountants at private companies would be more willing to whistleblow if offered the same protections. Future research may wish to explore additional factors that may be related to whether a professional accountant may choose to whistleblow; such variables may include guaranteeing one’s job, offering a cash reward, and organizational variables such as job satisfaction, organizational commitment, or various materiality levels in the ethical situation. Limitations of this study begin with the size of the sample and the location of the respondents is from one mid-Atlantic state which may limit the generalizability of these ﬁndings. Even with these limitations, this study provides a basis for future research and more importantly is the ﬁrst study to use the MES scale for whistleblowing intensions of practicing accountants. Further, we have provided interesting insights into the views of practicing accountants regarding whistleblowing for earnings management situations and encourage additional research in this area.

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ACKNOWLEDGMENTS We wish to thank Cynthia Jeffrey for her guidance through the review process and two anonymous reviewers for their time and constructive comments that greatly improved this manuscript. We also appreciate the feedback from participants at the American Accounting Association where an earlier version of this chapter was presented.

REFERENCES Ahern, K., & McDonald, S. (2002). The beliefs of nurses who were involved in a whistleblowing event. Journal of Advanced Nursing, 38, 303–309. Alford, C. F. (2001). Whistleblowers broken lives and organizational power. Ithaca, NY: Cornell University Press. Arnold, D. F., & Ponemon, L. A. (1991). Internal auditors perceptions of whistle-blowing and the inﬂuence of moral reasoning: an experiment. Auditing: A Journal of Practice and Theory, 10(2), 1–15. Barnett, T., Cochran, D. S., & Taylor, G. S. (1993). The internal disclosure policies of privatesector employers: An initial look at their relationship to employee whistleblowing. Journal of Business Ethics, 12, 127–136. Benson, J. A., & Ross, D. L. (1998). Sundstrand: A case study in transformation of cultural ethics. Journal of Business Ethics, 17, 1517–1527. Bernstein, M., & Jasper, J. M. (1996). Interests and credibility. Social Science Information, 35(3), 565. Bok, S. (1980). Whistleblowing and professional responsibilities. In: D. Callahan & S. Bok (Eds), Ethics teaching in higher education (pp. 2–10). New York: Plenum Press. Brabeck, M. M. (1984). Ethical characteristics of whistle-blowers. Journal of Research in Personality, 18, 41–53. Brody, B. A. (1970). Moral rules and particular circumstances. Englewood Cliffs, NJ: Prentice-Hall. Burns, J. (2004). Corporate governance (a special report): Is Sarbanes–Oxley working? We asked a variety of experts: Most of them said yes – with some caveats. Wall Street Journal (Eastern edition), p. R8. Callahan, E. S., Dworkin, T. M., Fort, T. L., & Schipani, C. A. (2002). Integrating trends in whistleblowing and corporate governance: Promoting organizational effectiveness, societal responsibility, and employee empowerment. American Business Law Journal, 40(1), 177–215. Chung, J., Monroe, G. S., & Thorne, L. (2004). An examination of affecting external and internal whistle-blowing by auditors. Working Paper, The University of NSW School of Accounting. Cohen, J. R., Pant, L. W., & Sharp, D. J. (1993). Culture-based ethical conﬂicts confronting multinational accounting ﬁrms. Accounting Horizons, 7(3), 1–13. Cohen, J. R., Pant, L. W., & Sharp, D. J. (1996). Measuring the ethical awareness and ethical orientation of Canadian auditors. Behavioral Research in Accounting, 8(Suppl), 98–119. Cohen, J. R., Pant, L. W., & Sharp, D. J. (1998). The effect of gender and academic discipline diversity on the ethical evaluations, ethical intentions, and ethical orientation of potential public accounting recruits. Accounting Horizons, 12(3), 250–270.

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Collins, A., & Schultz, N. (1995). A critical examination of the AICPA code of professional conduct. Journal of Business Ethics, 14(1), 31–41. Cruz, C. A., Shafer, W. E., & Strawser, J. R. (2000). A multidimensional analysis of tax practitioner’s ethical judgments. Journal of Business Ethics, 24(3), 223–245. Ewert, R., & Wagenhofer, A. (2005). Economic effects of tightening accounting standards to restrict earnings management. The Accounting Review, 80(4), 1101–1124. Felsburg, E. J. (2005). Understanding retaliation and whistleblowing claims. Employment Relations Today, 32(1), 91–96. Ford, R. C., & Richardson, W. D. (1994). Ethical decision-making: A review of the empirical literature. Journal of Business Ethics, 13, 205–221. Gilligan, C. (1982). In a different voice. Cambridge, MA: Harvard University Press. Grandossy, R., & Sonnenfeld, J. (2005). I see nothing, I hear nothing: Culture corruption and apathy. International Journal of Disclosure and Governance, 2(3), 228–243. Healy, P.M. & Wahlen, J.M. (1999). A review of the earnings management literature and its implications for standard setting. Accounting Horizons (December), 13, 365–383. Jasper (1990). Nuclear politics. Princeton, NJ: Princeton University Press. Jones, T. M. (1991). Ethical decision making by individuals in organizations: An issuecontingent model. Academy of Management Review, 16, 366–395. Kant, I. (1980). Lectures on ethics: Immanuel Kant; translated by Louis Infield; foreword by Lewis White Beck. Indianapolis, IN: Hackett Publishing Company. Keenan, J. P. (1990). Upper-level managers and whistleblowing: Determinants of perceptions of company encouragement and information about where to blow the whistle. Journal of Business and Psychology, 5(2), 223–235. Keenan, J. P. (2002). Comparing Indian and American managers on whistleblowing. Employee Responsibilities and Rights Journal, 14, 79–89. Label, W. A., & Miethe, T. D. (1999). Whistleblowing and external auditors. Journal of Applied Business Research, 15(2), 87–92. Ladd, J. (1973). Ethical relativism. Belmont, CA: Wadsworth Publishing Company. Latane, B., & Darley, J. (1970). The unresponsive bystander: Why doesn’t he help? New York: Appleton-Century Crofts. Loe, T. W., Farrell, L., & Mansﬁeld, P. (2000). A review of empirical studies assessing ethical decision-making in business. Journal of Business Ethics, 25, 185–204. Lovell, A. (2002). Ethics as a dependent variable in individual and organizational decision making. Journal of Business Ethics, 37(2), 145–163. Marshall, J., & Heffes, E. M. (2003). Financial execs who do the right thing. Financial Executive, Morristown, 19(8), 32. McKee, T. E. (2005). Earnings management: An executive perspective (1st ed.). New York: South-Western Educational Publishing. Miceli, M. P., & Near, J. P. (1985). Charateristics of organizational climate and perceived wrongdoing associated with whistle-blowing decisions. Personnel Psychology, 38, 525–544. Miceli, M. P., & Near, J. P. (1989). The incidence of wrongdoing, whistleblowing, and retaliation: Results of a natural occuring ﬁeld experiment. Employee Responsibilities and Rights Journal, 2, 91–108. Miceli, M. P., & Near, J. P. (1992). Blowing the whistle: The organizational and legal implications for companies and employees. Lexington, MA: Lexington Books. Miceli, M. P., Near, J. P., & Schwenk, C. R. (1991). Who blows the whistle and why? Industrial & Labor Relations Review, 45, 113–130.

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Miceli, M. P., & Near, J. P. (1995). Effective whistle-blowing. The Academy of Management Review, 20(3), 679–708. Mills, J. S. (1961). The philosophy of John Stuart Mill: Ethical, political, and religious. Edited and with an introduction by Marshall Cohen, Modern Library, New York. Myers, R. (1990). Classical and modern regression with applications (2nd ed.). Boston, MA: Duxbury. Near, J. P., & Miceli, M. P. (1987). Whistle-blowers in organizations: Dissidents or reformers? In: B. M. Straw & L. L. Cummings (Eds), Research in organizational behavior (Vol. 9, pp. 321–368). Greenwich, CT: JAI Press. Near, J. P., & Miceli, M. P. (1988). The internal auditor’s ultimate responsibility: The reporting of sensitive issues. Florida: The Institute of Internal Auditors Research Foundation, Altamonte Springs. Near, J. P., & Miceli, M. P. (1995). Effective whistleblowing. The Academy of Management Review, 20(3), 679–708. Near, J. P., Rehg, M. T., Van Scotter, J. R., & Miceli, M. P. (2004). Does type of wrongdoing affect the whistle-blowing process? Business Ethics Quarterly, 14(2), 219–242. Nelkin, D. (1971). Nuclear power and its critics. Ithaca, NY: Cornell University Press. O’Fallon, M. J., & Butterﬁeld, K. D. (2005). A review of the empirical ethical decision-making literature 1996–2003. Journal of Business Ethics, 59, 375–413. Pfeffer, J., & Salancik, G. R. (1978). The external control of organizations. New York: Harper & Row. Rawls, J. (1971). A theory of justice. Cambridge, MA: The Belknap Press of Harvard University Press. Reidenbach, R. E., & Robin, D. P. (1988). Some initial steps toward improving the measurement of ethical evaluations of marketing activities. Journal of Business Ethics, 7(11), 871–879. Reidenbach, R., & Robin, D. (1990). Toward the development of a multidimensional scale for improving evaluations of business ethics’. Journal of Business Ethics, 9, 639–653. Rest, J. R. (1986). Moral development: Advances in research and theory. New York: Praeger. Samuelson, J., & Gentile, M. (2005). Get aggressive about passivity. Harvard Business Review, 83(11), 18–20. Sennetti, J., Shawver, T., & Bancroft, P. (2004). The moral and cultural reasoning of IPO accountants: A small sample study. Research in Professional Responsibility and Ethics in Accounting, 9, 101–128. Shawver, T. J., & Clements, L. H. (2007). The intention of accounting students to whistleblow in situations of questionable ethical dilemmas. Research in Professional Responsibility and Ethics in Accounting, 11, 177–191. Shawver, T. J., Sennetti, J. T., & Bancroft, P. (2006). Can the ‘clan effect’ reduce the gender sensitivity to fraud? The case of the IPO environment. Journal of Forensic Accounting, 7, 185–208. Sidgwick, H. (1874). The methods of ethics (7th ed., 1907). London: Macmillan. Sims, R. L., & Keenan, J. P. (1998). Predictors of external whistleblowing: Organizational and intrapersonal variables. Journal of Business Ethics, 17(4), 411–422. Sweeney, P. (2005). Accommodating would-be whistleblowers. Financial Executive, Morristown, 21(2), 26–29. Spencer, J. B. (1987). The auditor and the informant. Internal Auditor, 44(1), 24–28.

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Trevino, L. K. (1986). Ethical decision-making in organizations: A person–situation interactionist model. Academy of Management Review, 11, 601–617. United States Congress. (1912). Lloyd-La Follette Act of 1912. Vinten, G. (1995). Audit committees, internal control, and corporate governance. Managerial Auditing Journal, 10(6), 3–4. Vinten, G. (2003). Whistleblowing: The UK experience, Part 1. Management Decision, 41(9), 935–943. Vroom, V. H. (1964). Work and motivation. New York: Wiley. Weinstein, D. (1979). Bureaucratic opposition. New York: Pergamon Press. Winﬁeld, M. (1990). Minding Your Own Business: Regulation and Whistleblowing in British Companies. Social Audit, London. Winﬁeld, M. (1994). Whistleblowers as corporate safety net. In: G. Vinten (Ed.), Whistleblowing: Subversion or corporate citizenship? (pp. 21–32). New York: St. Martin’s. Xu, Y., & Ziegenfuss, D. (2003). Reward systems, moral reasoning, and internal auditor’s whistleblowing behavior. Working Paper presented at the American Accounting Association 2003 Symposium on Ethics Research in Accounting.

APPENDIX Vignette Early Shipment A manager realizes that the projected quarterly sales ﬁgures will not be met, and thus the manager will not receive a bonus. However, there is a customer order which if shipped before the customer needs it will ensure the quarterly bonus but will have no effect on the annual sales ﬁgures. Action: The manager ships the order to ensure earning the quarterly sales bonus. Vignette Reduce Bad Debt The CEO of a company requests to the controller reduce the estimate for bad debts in order to increase reported income, arguing that this is common practice in the industry when times are hard. Historically, the company made very conservative allowances for doubtful accounts, even in bad years. The CEO’s request would make it one of the least conservative in the industry. Action: The controller makes the adjustment. Each vignette is rated by circling one number for each of the items below.

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probability that I would undertake the same action is High 1 probability that my peers would undertake the same action is High 1 action described above is Ethical 1 probability that I would whistleblow is High 1

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Unjust Unfair Not morally right Acceptable to my family Culturally unacceptable Traditionally acceptable Self-promoting for the actor Not personally satisfying for the actor Produces the least utility Maximizes beneﬁts while minimizes harm Violates an unwritten contract Does not violate an unspoken promise Shows no compassion of caring 3 4 5 6 7 Low 3 4 5 6 7 Low 3 4 5 6 7 Unethical 3 4 5 6 7 Low

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Just Fair Morally right Not acceptable to my family Culturally acceptable Traditionally unacceptable Not self-promoting for the actor Personally satisfying for the actor

MANAGERIAL INTENT AND THE ETHICS OF EARNINGS MANAGEMENT Keith G. Stanga and Andrea S. Kelton ABSTRACT This exploratory study has two primary objectives: 1. To determine potential stockholders’ current attitudes about the ethical acceptability of earnings management associated with certain accounting actions that require judgment and estimation and that managers undertake within the scope of generally accepted accounting principles. 2. To determine whether management’s intent in taking these accounting actions is related to the ethical acceptability of the actions to potential stockholders. The study uses three accounting methods that corporate managers may use to manage earnings and that have not been considered in prior research: bad debts, warranties, and depreciation. Three levels of intent are also examined: a desire to increase the company’s stock price; a desire to earn a performance-based bonus; and a business reason that relates to the accounting model, included for benchmarking purposes. Cases were applied in an experimental study that involved MBA students as potential stockholders. Results indicate that potential stockholders perceive the most ethically acceptable action to occur when managerial intent is a business reason Research on Professional Responsibility and Ethics in Accounting, Volume 12, 149–172 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1574-0765/doi:10.1016/S1574-0765(07)00207-5

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that relates directly to the accounting model. They perceive a less-ethical action when managers engage in accounting actions that are motivated by a desire to protect the company’s stock market price. They perceive the least ethical action to occur when managers are motivated by a desire to increase their own bonus. The two latter managerial intents are associated with earnings management. The results are consistent with the Jones (1991) theoretical model of ethical decision making by individuals. When management’s intent is associated with a higher concentration of effect, the accounting act has a higher moral intensity and is judged to be less ethical.

Earnings management has been called ‘‘probably the most important ethical issue facing the accounting profession’’ (Merchant & Rockness, 1994, p. 92). Additionally, regulators have expressed concern over the potentially harmful consequences of earnings management (e.g., Levitt, 1998). Healy and Wahlen (1999, p. 368) deﬁne earnings management as follows: Earnings management occurs when managers use judgment in ﬁnancial reporting and in structuring transactions to alter ﬁnancial reports to either mislead some stakeholders about the underlying economic performance of the company or to inﬂuence contractual outcomes that depend on reported accounting numbers.

Although earnings management is extremely difﬁcult for investors to detect, most investors believe that companies engage in it quite frequently (Hodge, 2003, p. 43). Auditors, who are close observers of managers throughout the ﬁnancial reporting process, have cited numerous examples of earnings management in practice (Nelson, Elliott, & Tarpley, 2003). A substantial body of accounting and ﬁnance literature demonstrates that managers have incentives to manage earnings and supports both the existence and the widespread nature of earnings management (for a comprehensive review of the literature on this subject, see Healy & Wahlen, 1999). Generally accepted accounting principles (GAAP) give corporate managers reasonable ﬂexibility to use estimates and apply judgment. This ‘‘within-GAAP ﬂexibility’’ allows a manager to apply GAAP to a company in a manner that the manager believes best reﬂects the company’s economic circumstances. However, this ﬂexibility also allows the manager to use GAAP to manage the company’s earnings to a desired outcome. This exploratory study has two primary objectives: (1) To determine potential stockholders’ current attitudes about the ethical acceptability of

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earnings management associated with certain accounting actions that require judgment and estimation and that managers undertake within the scope of GAAP. (2) To determine whether management’s intent in taking these accounting actions is related to the ethical acceptability of the actions to potential stockholders. The study focuses on MBA students in the role of potential stockholders, and the study’s cases focus on accounting decisions made by a company’s management. Although management is primarily responsible for ﬁnancial statements, accountants interact with and assist managers in discharging their responsibilities; thus, the study has important implications for accountants and for students who seek to become accountants. The Sarbanes–Oxley Act of 2002 requires CEOs and CFOs to certify that the ﬁnancial statements of a public company present fairly the company’s ﬁnancial condition and results of operations. Accountants seek to help managers provide relevant and reliable information that will help users of ﬁnancial statements, such as potential stockholders, to make informed decisions. If earnings management is associated with a decline in ethicality, accountants would need to take that fact into consideration when they advise managers about ﬁnancial accounting and reporting issues. In an experimental context, the study documents the current attitudes of a group of full-time MBA students (as potential individual investors) about the ethical acceptability of using estimates to apply three accounting methods, each within the scope of GAAP, which a corporate manager can potentially use to manage the company’s earnings: accounting for uncollectible accounts receivable (i.e., bad debts), accounting for warranties, and accounting for depreciation of plant assets. The study ﬁnds that managerial intent matters when evaluating the ethical acceptability of the accounting actions studied. When managerial intent suggests earnings management, participants judged the action as less ethical, even though the accounting action is still within GAAP and approved by external auditors. Consistent with Jones’ (1991) model of ethical decision making by individuals, the accounting action was judged as the least ethical when managerial intent suggested a more concentrated effect. Considerable variation in the ethical judgments was noted, indicating that participants did not agree on the ethical appropriateness of the accounting actions described in the cases. Interestingly, results differ from Kaplan (2001), who found that managerial intent did not affect non-shareholders’ ethical judgments. The study makes several contributions to research and practice. According to the earnings management deﬁnition provided by Healy and Wahlen (1999) and noted above, a manager’s use of accounting estimates to achieve a targeted earnings amount may be considered earnings

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management. Prior research has not explored how potential investors judge the use of accounting estimates to achieve income targets. This study provides some evidence suggesting that the ethicality of an accounting action depends on managerial intent. Additionally, this study was conducted during the ‘‘post-Enron’’ period of business history and provides evidence of current attitudes about the ethical acceptability of earnings management. Finally, because good ethics requires doing the right things, this study should be potentially useful in learning more about what the right things are today from an accounting perspective, as well as in learning more about the role of managerial intent when making ethical decisions about corporate ﬁnancial reporting. Results indicate that potential investors associate a manager’s use of accounting estimates to meet predetermined income targets with a decline in ethicality. Moreover, when managerial intent suggests a highly concentrated effect of an earnings management act, participants associate the act with a substantial decline in ethicality. Results should be of interest to corporate managers considering codes of conduct and/or laws to deter these types of behaviors. For example, is it ethically acceptable today for a manager to estimate bad debts expense with the intent to achieve an earnings level that allows the manager to earn a bonus? If this action is unacceptable and managers do it anyway, effective deterrents to this behavior need to be established.

BACKGROUND Corporate managers are responsible for preparing a company’s ﬁnancial statements, which the company communicates to users who make economic decisions. Potential stockholders comprise one major group of those users (FASB, 1978). When preparing ﬁnancial statements, managers must apply GAAP, which are those principles that have substantial authoritative support. GAAP have some inherent ﬂexibility by design, which most members of the ﬁnancial community consider desirable. For example, though managers must estimate a company’s bad debt expense each period to implement accrual accounting, managers have some latitude in formulating the estimate to consider the company’s unique circumstances. Likewise, when selecting accounting methods in such areas as inventory valuation and depreciation of plant assets, managers can select from among several acceptable alternatives to best reﬂect the company’s economic environment and circumstances. The normative goal of ﬁnancial reporting is to provide useful information to users to aid their decision making

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(FASB, 1978). Useful information is both relevant and reliable (FASB, 1980). An important aspect of reliability is neutrality, which means the ‘‘absence in reported information of bias intended to attain a predetermined result or to induce a particular mode of behavior (emphasis added)’’ (FASB, 1980, Glossary of terms). The most important single number in ﬁnancial statements is the company’s net income, or in other words, the company’s earnings (Lev, 1989, p. 155). Ideally, a company’s earnings should relate closely to the ﬁrm’s underlying economic performance. If a company has performed well (poorly) from an underlying economic perspective, its reported accounting earnings should be strong (weak). Earnings management occurs when a manager takes actions that change a company’s reported earnings in a way designed to affect the perceptions of the company’s economic performance in the minds of users of ﬁnancial statements. Thus, managed earnings are not neutral. Among the major motivations for managing earnings are the following: Meeting or exceeding the consensus earnings forecasts of ﬁnancial analysts, maximizing the proceeds received from selling the company’s shares, maximizing managerial bonuses that are based on the amount of reported net income, minimizing the chances of violating covenants in ﬁnancial contracts, and reducing earnings volatility (Mulford & Comiskey, 2002, pp. 83–84). A large body of accounting and ﬁnance literature provides evidence that earnings management is a widespread practice that occurs in these circumstances (Healy & Wahlen, 1999). Corporate managers can manage earnings by using operating methods or accounting methods (Merchant & Rockness, 1994, p. 83). Operating methods of managing earnings refer to making business operating decisions that are designed to produce desired earnings outcomes. Operating decisions affect the ﬁrm’s underlying economic reality; they produce earnings effects as well as cash ﬂow effects. Examples of operating decisions are engaging in advertising programs, engaging in research and development activities, and maintaining plant assets. If a manager defers expenditures for these types of items from the current year to a future year, a result is that the ﬁrm improves the current year’s net income. However, by delaying the expenditures, the ﬁrm must wait to derive economic beneﬁts from the actual advertising, research and development, or maintenance activities. Accounting methods of managing earnings refer to managers using the ﬂexibility inherent in GAAP to affect the timing of the reporting of revenues and/or expenses to produce a desired earnings outcome. For example, as long as the estimate is reasonable and defendable within GAAP, a manager

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may select a lower rather than a higher estimate of bad debts expense in a particular year with a result being to increase the current year’s net income. As another example, the ﬁnancial reporting choice of depreciation method for plant assets has no effect on the underlying economic reality of the ﬁrm. Yet a manager might select straight line rather than accelerated depreciation for plant assets to allow the ﬁrm to report a higher net income during the earlier years of a plant asset’s life. As the term is used in this chapter, earnings management differs from fraud (see Dechow & Skinner, 2000, p. 239). Earnings management occurs within the boundaries of GAAP and may range from conservative accounting to aggressive accounting, depending on how managers apply their judgment. The extent to which earnings management is ‘‘good’’ or ‘‘bad’’ is a complex matter that has not been resolved, and opinions on the subject differ (Arya, Glover, & Sunder, 2003; Mulford & Comiskey, 2002, p. 82). Neither the Financial Accounting Standards Board nor the Securities and Exchange Commission (SEC) has proscribed earnings management. In contrast, fraudulent accounting violates GAAP and is clearly unethical and illegal. Fraudulent accounting actions include recording ﬁctitious sales, backdating sales invoices, and overstating inventory by recording ﬁctitious inventory (Dechow & Skinner, 2000, p. 239). Prominent examples of companies recently found or alleged to have engaged in fraud include Enron, WorldCom, and HealthSouth. The present study relates most closely to two previous studies in the area of ethics and earnings management. Merchant and Rockness (1994) reported an initial, survey study on the ethics of earnings management. They administered a questionnaire to participants at two corporations and to members of a chapter of the Institute of Internal Auditors who made ethical judgments from the perspective of managers of a major division of a billion-dollar public company. Merchant and Rockness (1994) produced some initial, limited evidence which suggested that a manager’s purpose in earnings management was a concern to the study’s participants. Participants judged a single earnings management action taken with the intent ‘‘to make budgeted proﬁt targets’’ for a division of a company as less ethical than an earnings management action that helps the division ‘‘to be able to continue working on some important product development projects that might have been delayed due to budget constraints’’ (see Bruns & Merchant, 1989, p. 221, for the questionnaire). Building on the work of Merchant and Rockness (1994), Kaplan (2001) reported an experiment involving MBA students to provide evidence about why ethical judgments may differ across groups, depending on the role of

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the individual making the judgment and the intended beneﬁt to be derived from managing earnings. Kaplan (2001) examined the effect of managerial intent on ethical judgments of earnings management from the perspectives of shareholder versus non-shareholder roles. Two levels of managerial intent were examined: earnings management to help the company achieve ﬁnancial goals (company intent) and earnings management to achieve a ﬁnancial target that would ensure a bonus for the manager (individual intent). Each study participant evaluated three scenarios: an accounting gain scenario, an accounting loss, and an operating gain scenario, with each scenario involving a manager engaged in earnings management. Applying an egocentric interpretation of ethics to earnings management, Kaplan (2001) found that present shareholders judge the company intent under the operating gain scenario as more ethically favorable than the individual intent. Managerial intent did not have any effect on the ethical judgments of present shareholders for the accounting gain scenario or the accounting loss scenario, which demonstrates that the effect of managerial intent on ethical judgments about earnings management may differ depending on the type of earnings management practice.1 Moreover, presumably because non-shareholders do not beneﬁt from a self-interested economic perspective from the earnings management actions of management, the ethical judgments of non-shareholders were unrelated to management’s intent for any of the three earnings management scenarios.

HYPOTHESES This exploratory study seeks to provide evidence about current attitudes toward earnings management in the present, ‘‘post-Enron’’ period of business history. Jones (1991, p. 371) developed a model of individual ethical decision making that is issue contingent, such that ‘‘characteristics of the moral issue itself, collectively called moral intensity, are important determinants of ethical decision making and behavior.’’ Jones (1991) suggests six components that affect the moral intensity of an ethical issue: magnitude of consequences, social consensus, probability of effect, temporal immediacy, proximity, and concentration of effect. Magnitude of consequences refers to the total harms (or beneﬁts) resulting from a speciﬁc act. Social consensus refers to the level of agreement that an act is ethical or unethical. Probability of effect refers to the probability that the act and the related consequences will actually occur. Temporal immediacy refers to the length of time between

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the act and its consequences. Proximity refers to the ‘‘feeling of nearness’’ that the decision maker has for the victims (or beneﬁciaries) of the act. Finally, concentration of effect is an inverse function of the number of people affected by an act of a given magnitude.2 An increase in any or all of these six components results in an increase in the moral intensity of an act. The relevance of each component of moral intensity to an ethical decision is dependent on the speciﬁc decision making scenario; not all components will be relevant to each context (Jones, 1991; Shafer, 2002). In the present study, concentration of effect appears to be particularly relevant. The concentration of effect associated with the accounting issues examined in this study should vary depending on managerial intent. Archival accounting research has shown that managers have incentives to manage earnings to maximize earnings-based compensation (bonus intent) (see Healy & Wahlen, 1999). Earnings management to earn a bonus for the manager has a highly concentrated effect because only the manager will beneﬁt, and may beneﬁt signiﬁcantly, from the accounting action. According to the Jones (1991) model, this highly concentrated effect will increase the moral intensity of the act for the bonus intent and strongly inﬂuence the perceived ethicality. Additionally, research in accounting and ﬁnance has demonstrated that managerial intentions to increase the company’s stock price (stock market intent) appear to motivate some accounting decisions (Healy & Wahlen, 1999). Research has also shown that stockholders may beneﬁt economically through appreciated share prices from earnings management for the stock market intent (Dye, 1988). The concentration of effect of the stock market intent, and, subsequently the moral intensity, is less than the bonus intent. Earnings management to protect a company’s stock price may result in increased investment value for all stockholders; thus, the number of individuals who may beneﬁt from the act for the stock market intent is substantially greater than the number that beneﬁts from the bonus intent. Since any potential beneﬁts of earnings management will be widely distributed among shareholders, the amount of beneﬁt to most individual shareholders will be relatively small (Shafer, 2002). Due to the low concentration of effect, we expect the stock market intent to have less moral intensity than the bonus intent and, therefore, to be perceived as more ethical than the bonus intent. Prior to making an ethical judgment, an individual must ﬁrst recognize that a moral issue exists (Jones, 1991). Accounting decisions may be made based on a business reason that directly relates to the accounting model (business intent). The business intent is not considered earnings

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management (according to the deﬁnition provided by Healy & Wahlen, 1999) and should not be considered a moral issue. Thus, we expect that the business intent will not be considered a moral issue and will be judged as highly ethical. The following hypotheses are proposed: H1. Potential stockholders will judge the business intent as more ethical than the stock market intent and the bonus intent. H2. Potential stockholders will judge the stock market intent as more ethical than the bonus intent.

RESEARCH METHODS Design The study has two independent variables: managerial intent and accounting case. One dependent variable, ethical acceptability, is analyzed. The study used a 3 (business intent, stock market intent, and bonus intent) 3 (bad debts case, warranty case, and depreciation case) design, with repeated measures on the accounting case factor. The order of the cases was randomized and each participant was randomly assigned to one of the three managerial intents. Giving each participant only a single managerial intent helped to protect against a possible demand effect. In other words, this design feature was implemented to prevent participants from potentially comparing the three managerial intents and trying to determine a ‘‘correct’’ answer. Managerial intent that motivated the accounting estimate was manipulated at the following three levels: 1. Business intent that relates directly to the accounting model. In the bad debts case, for example, the business intent indicated that the company’s customers are considered very good credit risks and therefore selecting the lowest number in the reasonable range for bad debts expense is justiﬁed. Similar business rationales were stated in the warranty and depreciation cases. The business intent represents a benchmark to allow comparison among the managerial intents; it does not involve earnings management. 2. Stock market intent. Participants were told that the manager in each case was concerned that the company would be unable to meet analysts’ consensus earnings forecasts for the year, and as a result the company would experience a potentially sharp drop in stock price.

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3. Bonus intent. Participants were told that the manager in each case wanted the company’s net income for the year to be as high as possible to ensure that the manager would receive the maximum bonus from the company. Accounting case is manipulated within-subjects at three levels: accounting for uncollectible accounts receivable (i.e., bad debts), accounting for warranties, and accounting for depreciation of plant assets. According to a recent survey of several prominent groups in the ﬁnancial community, the timing of operating expenses (such as those speciﬁcally considered in this study) represents, by far, the most common earnings management technique observed in practice (Mulford & Comiskey, 2002, p. 144). The present study extends prior research, in part by focusing on accounting methods of managing earnings not previously considered in research on the ethics of earnings management. The accounting practices considered in this study are subtle, in the sense that each is associated with a year-end adjusting entry that simply requires selecting a single point-estimate from a range of numbers considered acceptable to the company’s internal accountants and external auditors. In contrast, the earnings management scenarios used in prior research (Merchant & Rockness, 1994; Kaplan, 2001) involved accounting actions that may be considered ﬁnancial statement fraud, such as postponing billings to next year for work performed in the current year and needlessly raising the amount in the account for outdated inventory (Shafer, 2002).

Task This study involved an experiment conducted in a classroom with full-time MBA students as potential stockholders. Potential stockholders are an important group of external users of ﬁnancial statements (FASB, 1978). Potential stockholders use earnings to help them make predictions about future cash ﬂows and evaluate management’s effectiveness. Each participant received a packet containing an informed consent form (as required by the university), a set of instructions, three cases, and a request for demographic information. The instructions explained that each of the three cases described accounting actions taken by upper-level managers of three different large, publicly traded companies. Following each case was a managerial intention that explained why the accounting action was taken. Participants were told to assume that the intention stated in each case was the true intention of the manager. Participants were also

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told to adopt the frame of reference of a potential stockholder (i.e., a member of the investing public) in each company described in the cases. Each case involved a ﬁnancial accounting and reporting decision in which the company’s CFO and external auditors agreed that a certain range stated in the case would be reasonable, in accordance with GAAP, and considered material for the company. The fact that each case is within GAAP is particularly important because the cases do not deal with fraud, which is obviously unethical. Instead, the cases deal with managerial behaviors that are more nuanced and not as obviously wrong as fraudulent ﬁnancial reporting. The upper-level manager in each case had decided to use the lowest end of the reasonable range to report dollar amounts in each of the three cases (bad debts expense, warranty expense, and depreciation expense). By reporting the dollar amount of the expense at the lowest end of the reasonable range, the effect was to make net income as high as possible. Participants were asked to evaluate the ethical acceptability of the accounting action undertaken by management for the indicated true intention. To enhance the chapter’s contribution, the cases purposely dealt with accounting methods that were different from those considered in prior research. Yet the cases built on previous research in the following ways: The cases focused on accounting methods as opposed to operating methods of managing earnings. The present study probes the ethicality of earnings management using accounting methods that have not been considered in previous research. The cases focused on results that had been deemed to be material to the company to reﬂect Merchant and Rockness’ (1994) ﬁnding that larger earnings management actions are judged less ethically than smaller earnings management actions. The cases focused on annual earnings as opposed to quarterly earnings to reﬂect Merchant and Rockness’ (1994) ﬁnding that managers judged annual earnings management actions as less ethical than quarterly earnings management actions. The cases placed each participate into a particular role. Speciﬁcally, each participant was asked to assume the role of a potential stockholder (i.e., member of the investing public). Kaplan (2001) found some preliminary evidence that role mattered, at least to the extent of one of the three cases used in the study, when judging ethical acceptability. In the present study, a decision was made to hold role constant and deal only with potential stockholders.

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Subjects The experiment was conducted in December 2003 with 57 full-time MBA students as participants at a large, comprehensive state university in the United States.3 MBA students are widely used as surrogates for potential stockholders in accounting research. MBA students are typically more mature than undergraduates and many already have business experience. MBA students are familiar with ﬁnancial statements and many have general investing experience. This group of MBAs had prior coursework in ﬁnancial accounting that was presented to them primarily from the standpoint of users of ﬁnancial statements. Participants responded anonymously.4

Dependent Variable The dependent variable is ethical judgments of earnings management. Participants used the scale below to evaluate ethical acceptability, and the scale responses served as the study’s dependent variable.5 Very Ethical 1 2

3

4

5

6

7

Very Unethical 8 9

FINDINGS Demographic Data Table 1 summarizes the demographic characteristics of the study’s participants. As shown, the mean age was 26.71 years. On average, participants had 4.58 years of work experience and had completed three accounting courses. Approximately 38 percent of the participants were female. Most participants had already invested in common stocks, and almost everyone planned to invest in common stocks in the future.6 Virtually all participants had read a corporate annual report. Overall, it is reasonable to expect that these participants could adopt the frame of reference of a member of the investing public, as the present study required.

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Table 1. Participant Demographics.

Panel A: Continuous variables Age Years of work experience Number of accounting courses completed

Panel B: Dichotomous variables Gender Female Male Have you invested in common stock in the past? Yes No Do you plan to invest in common stock in the future? Yes No Have you previously read an annual report? Yes No

Mean

SD

26.71 4.58 3.00

3.76 3.97 1.76

n

%

21 35

37.50 62.50

32 25

56.14 43.86

55 1

98.21 1.79

56 1

98.25 1.75

Demographic data were analyzed to ensure randomization between experimental groups. No signiﬁcant differences (po0.05) between experimental groups were observed for the demographic variables noted in Table 1.

Descriptive Statistics Table 2 shows the descriptive statistics for the three managerial intentions for each of the three accounting cases. Recall that on the response scale, ‘‘1’’ indicated very ethical, while ‘‘9’’ indicated very unethical. As shown, the mean ethical judgments for the three managerial intentions are in the hypothesized order. The mean responses reveal the ‘‘big picture’’ of the study and indicate that the business intent is most ethical (overall mean ¼ 2.69), the stock market intent is less ethical (4.49), and the bonus intent is the least ethical (5.85). Importantly, the bonus intent mean is tilted toward the unethical side of the response scale.

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Table 2. Effect of Accounting Case and Managerial Intent on Ethical Acceptability.a Mean (SD) [Sample Sizes]. Managerial Intent

Accounting Case

Main Effects

Depreciation

Bad debt

Warranty

Business

2.61 (1.88) [18]

2.83 (1.29) [18]

2.61 (0.92) [18]

2.69 (1.40) [54]

Stock market

3.84 (1.50) [19]

4.63 (1.57) [19]

5.00 (1.53) [19]

4.49 (1.58) [57]

Bonus

5.65 (1.95) [20]

6.00 (1.69) [20]

5.90 (1.71) [20]

5.85 (1.76) [60]

a

Participants responded to questions accessing the ethical acceptability of management’s actions using a 9-point scale anchored by ‘‘very ethical’’ (1) and ‘‘very unethical’’ (9).

The standard deviations in Table 2 reveal considerable variation among the participants in their ethical judgments. The standard deviations show that, regardless of management’s intent, participants were not unanimous in their judgments about the ethical appropriateness of the accounting actions described in the cases. The response variability is especially interesting because each case involved a ﬁnancial reporting decision in which the company’s CFO and external auditors agreed that the accounting action was reasonable and in accordance with GAAP. This ﬁnding shows that the ethical acceptability of certain managerial judgments is presently unclear, even among those judgments made within the scope of GAAP. To further demonstrate the variation in subject responses, Table 3 shows a frequency distribution of the number of responses on each point of the ethical scales for each of the three intentions. This information is depicted in the form of a chart in Fig. 1. As shown, the vast majority of the responses for the business intent lie toward the ethical side of the response scale (modal response ¼ 2). For the stock market intent, the responses were bimodal (modes ¼ 3 and 6) with one mode leaning to the ethical side of the response scale and the other leaning to the unethical side. Most responses for the stock market intent were divided between 3, 4, 5, and 6. Thus, the participants showed considerable variation when assessing the ethical acceptability of accounting actions taken when management’s intent was

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Table 3. Participants’ Ethical Assessment Frequencies. Ethical Assessmenta

Managerial Intent

Business n % Stock market n % Bonus n %

1

2

3

4

5

6

7

8

9

7 12.96

22 40.74

17 31.48

3 5.56

2 3.70

0 –

3 5.56

0 –

0 –

0 –

6 10.53

12 21.05

11 19.30

11 19.30

12 21.05

3 5.26

2 3.51

0 –

0 –

1 1.67

8 13.33

8 13.33

5 8.33

8 13.33

20 33.33

10 16.67

0 –

a

Participants responded to questions accessing the ethical acceptability of management’s actions using a 9-point scale anchored by ‘‘very ethical’’ (1) and ‘‘very unethical’’ (9).

to protect the company’s stock price. When the intent was maximization of management’s bonus, the modal response was 7, which lies toward the unethical side of the response scale. Twenty participants rendered the modal response of 7; 10 participants rendered the next most frequently occurring response, an 8.

Hypotheses Tests Hypotheses were tested using repeated measures analysis of variance (ANOVA) with managerial intent and case as the independent variables and ethical judgments as the dependent variable. Hypothesis 1 predicts that potential stockholders will judge the business intent as more ethical than both the stock market intent and bonus intent. Hypothesis 2 predicts that potential stockholders will judge the stock market intent as more ethical than the bonus intent. ANOVA results are presented in Panel A of Table 4. As expected, managerial intent was signiﬁcant. The interaction between managerial intent and case was also signiﬁcant. To provide additional insight into the signiﬁcant interaction, a separate one-way, between-subjects ANOVA was performed on each case with managerial intent as the independent variable. Results are shown in Panel B of Table 4. These tests reveal that managerial intent was signiﬁcant for each of the three cases. Consistent with the study’s expectation, managerial intent

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KEITH G. STANGA AND ANDREA S. KELTON 25

Frequency

20 15 10 5 0 (A)

1

2

3

4 5 6 Ethical Assessment

7

8

9

1

2

3

4

7

8

9

1

2

3

7

8

9

14 Frequency

12 10 8 6 4 2 0 (B)

5 6 Ethical Assessment

25

Frequency

20 15 10 5 0 (C)

Fig. 1.

4 5 6 Ethical Assessment

Participants’ Ethical Assessment Frequencies. (A) Business Intent. (B) Stock Market Intent. (C) Bonus Intent.

Managerial Intent and the Ethics of Earnings Management

Table 4. df Panel A: ANOVA summary table Between-subjects effect Managerial intent (MI) 2 Within-subjects effect 1.848 Accounting case (AC)a MI ACa 3.697 Case

df

SS

165

Hypotheses Tests. SS

MS

F

Signiﬁcance

285.42

142.71

22.3

o0.001

8.09 6.97

4.376 1.885 MS

Panel B: Simple effect tests using one-way ANOVA Bad debt 2 95.22 47.61 Warranty 2 107.96 53.98 Depreciation 2 89.21 44.6

6.54 2.82

0.003 0.033

F

Signiﬁcance

20.26 26.01 13.89

o0.001 o0.001 o0.001

a

Univariate analysis performed using the Huynh–Feldt adjustment to correct for violation of the assumption of sphericity according to the criteria provided by Stevens (2002). Adjusted results have been presented.

signiﬁcantly affected the participants’ ethical judgments in the bad debts case, the warranty case, and the depreciation case. Bonferroni post hoc comparisons show that the mean ethical judgments for each of the three intentions are all signiﬁcantly different (po0.05). Since Table 2 shows that the means are in the predicted direction, H1 and H2 are both supported. An unexpected result was the signiﬁcant effect of accounting case shown in Panel A of Table 4. In order to explore this ﬁnding further, a separate one-way, repeated measures ANOVA was performed on each managerial intent (Table 5) with case as the independent variable. As shown, accounting case was not signiﬁcant for the business intent or the bonus intent; however, accounting case was signiﬁcant for the stock market intent. This indicates that for the business intent and the bonus intent, the participants’ ethical judgments were unaffected by whether the case involved depreciation, bad debts, or warranties. On the other hand, the nature of the case affected the participants’ ethical judgments when management’s intent was to increase the company’s stock price. Fig. 2 shows a plot of the interaction between managerial intent and case on the participants’ ethical judgments. The graph shows a high degree of convergence between the three cases on the business intent and bonus intent, but considerably less convergence on the stock market intent. When

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Table 5. Effect of Accounting Case on Ethical Assessments Using Repeated Measures ANOVA. Managerial Intent Businessa Stock market Bonusa

df

SS

MS

F

Signiﬁcance

1.554 2 1.263

0.593 13.30 1.30

0.381 6.649 1.029

0.359 10.24 1.607

0.649 o0.001 0.221

a

Univariate analysis performed using the Huynh–Feldt adjustment to correct for violation of the assumption of sphericity according to the criteria provided by Stevens (2002). Adjusted results have been presented.

7.00 6.00

Ethical Acceptibility

5.00 4.00 3.00 2.00 1.00 0.00 Business

Stock Market

Bonus

Managerial Intent Depreciation

Fig. 2.

Bad Debt

Warranty

Plot of Interaction Between Managerial Intention and Accounting Case.

management’s intent was to raise the company’s stock price, the participants’ ethical judgments were most favorable in the depreciation case and least favorable in the warranty case. This unexpected result illustrates the importance of using multiple case scenarios in this type of

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research. It also illustrates the importance of conducting research in this area using a variety of accounting methods. Unlike prior research, the cases developed for this study were purposely conﬁned to accounting methods (as opposed to operating methods) of managing earnings. Moreover, this study was conﬁned to accounting methods that require managerial estimates. Although by design the study focused only on accounting methods, the results still show that the speciﬁc accounting method had some impact when management’s intent was to raise the company’s stock price.

DISCUSSION The extent to which earnings management is ‘‘good’’ or ‘‘bad’’ is a complex matter, and opinions on the subject differ (Arya et al., 2003; Mulford & Comiskey, 2002, p. 82). This study examined earnings management from an ethical perspective. Overall, results show that managerial intent is important to potential stockholders when judging the ethical acceptability of the accounting actions considered in this study. Consistent with the Jones (1991) model of ethical decision making, an intent that produces a highly concentrated effect increases the perceived moral intensity of the action and results in a more extreme judgment regarding ethical acceptability. These ﬁndings differ from Kaplan’s (2001, p. 27) conclusion that ‘‘intent did not inﬂuence ethicalness assessments among non-shareholders’’ (emphasis added). The differing results may be explained by differences in the accounting issues studied and in the timing of the two studies. Unlike Kaplan’s study, the present study focuses on earnings management within the context of accounting estimates. Moreover, this study was conducted after the recent, high-proﬁle accounting scandals and the passage of the SOX, which has brought forth a renewed emphasis on accounting and business ethics. The difference between the studies underscores the need for multiple studies in this important area using different methods that might be used to manage earnings. This study’s results indicate that when management’s true intent regarding an accounting action involved a business reason, as opposed to a reason that involved achieving an earnings target, participants judged the accounting action as the most ethical. To follow the highest ethical standards, corporate managers should undertake accounting actions involving estimates and judgments for business reasons that relate directly to the accounting model and should report earnings information that is neutral.

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Therefore, a company should not manage its earnings if the company wants to observe, and be seen to observe, the highest ethical standards. When management’s true intent was to maximize management’s own bonus, the accounting action was judged to be the least ethical. In fact, the participants’ overall ethical assessment leaned toward the unethical side of the response scale. Recall that by design, none of the accounting actions in this study were fraudulent or illegal. In fact, each accounting action is fairly common, exists within the scope of GAAP, and was reasonable and acceptable to the company’s CFO and external auditors in each of the study’s three cases. Nevertheless, when management’s true intent was bonus maximization, the participants judged the ethicalness of the accounting actions relatively harshly. This ﬁnding is consistent with Jones’ (1991) model in that the bonus intent for managing earnings yields greater moral intensity by exerting a more highly concentrated effect. Finally, when management’s intent was to protect the company’s stock price, the ethical appropriateness was judged to lie between the business intent and the bonus intent. This result suggests that the participants viewed protecting the company’s stock price as potentially helpful to both the company’s present stockholders and its management. In other words, by protecting the stock price, the manager helps present stockholders, which is not a purely selﬁsh motive. Results suggest that the stock market intent has a less concentrated effect and lower perceived moral intensity than the bonus intent. An unexpected result was that participants’ ethical judgments of the stock market intent varied depending on the speciﬁc accounting scenario. More research is needed to explain this ﬁnding, although it illustrates the importance of using multiple case scenarios and a variety of accounting methods when conducting research on the ethics of earnings management. Interestingly, considerable variation exists among participants’ ethical judgments of the cases in this study, which suggests the need for more education and guidance in this area of moral judgment. This ﬁnding has implications for standard setters and corporations considering codes of conduct and/or laws to more clearly articulate the ethical acceptability of certain types of behaviors. Management’s true intent affected ethical judgments of the accounting cases considered in this study. Psychology research has demonstrated that intent is a strong predictor of human behavior (Fishbein & Ajzen, 1975). Yet, determining a manager’s true intent in a speciﬁc instance may be challenging when it differs from the manager’s stated intent. A critical element in the ethical effectiveness of any organization is the tone that is set at the top of the organization (Copeland, 2005, p. 40). That is why it is especially important for all managers to

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behave at all times according to the highest ethical standards. If top managers are truly and consistently ethical, investors can have greater conﬁdence that the managers are making decisions for the right reasons, that stated intentions are true intentions, and that managers are looking after a broader set of interests in the ﬁrm as opposed to only the manager’s personal interests. In the United States, the SOX has initiated some of the most far-reaching changes to the accounting profession since the Securities Act of 1933 and the Securities Exchange Act of 1934. Building on the SOX, the SEC recently required registrants to create and publicly disclose a formal code of ethics that applies to senior corporate managers, including the CEO (SEC, 2003). SEC rules do not specify the details that a company must put into its code of ethics. However, the rule states (in part) that the code should consist of written standards that are reasonably designed to deter wrongdoing, ‘‘and promote honest and ethical conduct, including ethical handling of actual or apparent conﬂicts of interest between personal and professional relationships’’ (SEC, 2003, Section II). Although laws and codes of ethics cannot guarantee good ethics, the new SEC rule should help to ensure proper ethical behavior among corporate managers. The study’s results are timely in the light of major changes occurring within companies today. A recent survey of CEOs, CFOs, and internal audit directors shows that companies are adjusting to the SOX with a renewed emphasis on ethics, corporate governance, and ﬁnancial reporting quality. The study found evidence of such actions within corporations as having CFOs and controllers complete annual ethics and fraud training, greater focus on accurate ﬁnancial reporting and less on creative accounting, having the CFO emphasize the importance of accurate ﬁnancial reporting regardless of consequences, and looking more closely at the accounting numbers (Carpenter, Fennema, Fretwell, & Hillison, 2004). Despite the encouraging changes noted above, a recent survey of CFOs summarized in Fortune magazine shows that about half feel under about the same amount of pressure ‘‘to make the numbers work’’ as they felt prior to the SOX. Surprisingly, almost one-ﬁfth felt even more pressure today to make the numbers work (Demos, 2004). These ﬁndings suggest that notwithstanding the changes associated with Sarbanes–Oxley, a need still exists for an even more intense focus on ethical considerations when making ﬁnancial accounting and reporting decisions. Results from this study indicate that earnings management, whether motivated by a stock market intent or a bonus intent, is associated with a decline in ethicality. Thus, those interested in improving ﬁnancial reporting

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should not dismiss the subject of earnings management lightly (for example, with such statements as ‘‘earnings management has gone on in business for a long time,’’ ‘‘virtually all companies engage in earnings management,’’ and so forth). One message from this study is reasonably clear and direct: A company that chooses to manage its earnings using the methods examined in this study is also choosing to operate at a lower level of ethicality. A limitation of this study is that it uses MBA students as surrogates for potential stockholders. Although MBA students are reasonable surrogates and using them in a single classroom setting allowed control of the experimental conditions, additional useful insights might be learned by sampling from other groups. One group is executive MBAs, who ordinarily have more work experience and/or investment experience than regular MBAs. Another group might be obtained by sampling from a predetermined population of potential stockholders, such as members of an investment club or society. In general, more research is needed involving other groups of participants in the ﬁnancial reporting process. The MBA students in this study were told to view the case scenarios from the viewpoint of potential stockholders. They were also told to assume that the intent stated in the cases was the true intent of management. Despite these directions, we acknowledge that some participants may have been inﬂuenced by viewpoints other than potential stockholders and by prior beliefs regarding the true intentions of management. This study considered three accounting methods involving estimates that had not been considered in previous research. Additional research is needed to learn more about the ethical acceptability of earnings management involving other accounting methods and operating methods of managing a company’s earnings. Both previous research and the present study indicate that the methods used to manage earnings matter when judging ethicality. Additional research is also needed to learn more about why the participants’ ethical judgments for the stock market intent were bimodal – with one mode tilted toward the ethical side of the response scale and the other tilted toward the unethical side. This result suggests that at least some potential stockholders might expect (and perhaps even require) managers to engage in earnings management when needed to protect the market price of the company’s stock. Does such an expectation exist among potential stockholders, and if so, how widespread is the expectation and how ethical is it? Is this an area where additional ethical clarity is needed from leaders in the ﬁnancial community? This study involved management choosing an accounting expense estimate at the lowest end of an acceptable range, the achievement of an

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earnings target, and a clearly stated managerial intent. An extension of the study might involve a comparison of a mid-point with the lowest point in an acceptable range and build a context in which management’s intent is ambiguous. Despite the limitations, we believe that this study offers important and timely insights about one of the most important ethical issues that the accounting profession faces.

NOTES 1. Kaplan (2001) also noted the ‘‘importance of including multiple earnings management scenarios’’ when conducting this type of research. 2. Jones (1991, pp. 377–378) uses the following examples to clarify the meaning of concentration of effect: ‘‘(1) A change in a warranty policy denying coverage to 10 people with claims of $10,000 has a more concentrated effect than a change denying coverage to 10,000 people with claims of $10. (2) Cheating an individual or small group of individuals out of a given sum has a more concentrated effect than cheating an institutional entity, such as a corporation or governmental agency, out of the same sum.’’ We acknowledge the existence of ethical perspectives other than the philosophy reﬂected by Jones (1991), but a discussion of these perspectives is beyond the scope of this chapter. 3. Prior to the experiment, a group of Ph.D. students reviewed the cases for content and accuracy. Subsequently, the cases were formally pre-tested in classes of junior-level, undergraduate accounting majors. The pre-test did not uncover any problems with the cases, and only a few relatively minor wording changes were made in the ﬁnal instruments before administering them to the MBAs. 4. At the end of the packet of materials, each participant responded to a manipulation check that asked whether the accounting action described in the cases had the effect of increasing or decreasing the company’s net income. Only one participant missed the manipulation check, and that individual’s responses are excluded from the analysis in the chapter. The study’s ﬁndings are based on the responses of 57 participants instead of 58. Additionally, space was provided for participants to make comments about the study, and no comments suggested a lack of understanding of the task. 5. A 9-point scale was used to assess ethical judgments based on prior research in this area (Kaplan, 2001). 6. Results were not statistically different between participants who had previously invested in common stock and those who had not.

REFERENCES Arya, A., Glover, J. C., & Sunder, S. (2003). Are unmanaged earnings always better for shareholders? Accounting Horizons, 17(Suppl.), 111–116.

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Bruns, W. J., & Merchant, K. A. (1989). Ethics test for everyday managers. Harvard Business Review, 67(2), 220–221. Carpenter, T. D., Fennema, M. G., Fretwell, P. Z., & Hillison, W. (2004). A changing corporate culture. Journal of Accountancy, 197(March), 57–63. Copeland, J. E., Jr. (2005). Ethics as an imperative. Accounting Horizons, 19(March), 35–43. Dechow, P. M., & Skinner, D. J. (2000). Earnings management: Reconciling the views of accounting academics, practitioners, and regulators. Accounting Horizons, 14, 235–250. Demos, T. (2004). By the numbers. Fortune, 149(June 28), 30. Dye, R. A. (1988). Earnings management in an overlapping generations model. Journal of Accounting Research, 26(2), 195–235. FASB Statement of Financial Accounting Concepts No. 1. (1978). Objectives of financial reporting by business enterprises. Stamford, CT: FASB. FASB Statement of Financial Accounting Concepts No. 2. (1980). Qualitative characteristics of accounting information. Stamford, CT: FASB. Fishbein, M., & Ajzen, I. (1975). Belief, attitude, intention, and behavior: An introduction to theory and research. Reading, MA: Addison-Wesley. Healy, P. M., & Wahlen, J. M. (1999). A review of the earnings management literature and its implications for standard setting. Accounting Horizons, 13(December), 365–383. Hodge, F. D. (2003). Investors’ perceptions of earnings quality, auditor independence, and the usefulness of audited ﬁnancial information. Accounting Horizons, 17(Suppl.), 37–48. Jones, T. M. (1991). Ethical decision making by individuals in organizations: An issuecontingent model. Academy of Management Review, 16(2), 366–395. Kaplan, S. E. (2001). Further evidence on the ethics of managing earnings: An examination of the ethically related judgments of shareholders and non-shareholders. Journal of Accounting and Public Policy, 20, 27–44. Lev, B. (1989). On the usefulness of earnings and earnings research: Lessons and directions from two decades of empirical research. Journal of Accounting Research, 27(Suppl.), 153–201. Levitt, A. (1998). The numbers game. Remarks delivered at the NYU Center for Law and Business. New York, NY. Merchant, K. A., & Rockness, J. (1994). The ethics of managing earnings: An empirical investigation. Journal of Accounting and Public Policy, 13, 79–94. Mulford, C. W., & Comiskey, E. E. (2002). The financial numbers game: Detecting creative accounting practices. New York: Wiley. Nelson, M. W., Elliott, J. A., & Tarpley, R. L. (2003). How are earnings managed? Examples from auditors. Accounting Horizons, 17(Suppl.), 17–35. Securities and Exchange Commission. (2003). Final rule: Disclosure required by Sections 406 and 407 of the Sarbanes–Oxley Act of 2002. Washington, DC: SEC. Shafer, W. E. (2002). Effects of materiality, risk, and ethical perceptions on fraudulent reporting by ﬁnancial executives. Journal of Business Ethics, 38, 243–262. Stevens, J. (2002). Applied multivariate statistics for the social sciences. Mahwah, NJ: Lawrence Erlbaum Associates.

SELF-SERVING BIAS, RESPONDENT KNOWLEDGE, AND PERCEPTIONS OF NON-AUDIT SERVICES’ IMPACT ON AUDITOR INDEPENDENCE John M. Thornton, Alan Reinstein and Cathleen L. Miller ABSTRACT A long-standing debate exists on whether external auditor independence is impaired when public accounting firms provide non-audit services to their audit clients. Much recent research has focused on auditor independence in fact, though standard-setters consider auditor independence appearance as equally important. This study examines the appearance (or perception) of auditor independence when such services are provided, empirically testing two prominent explanations – self-serving bias and respondent knowledge – given for why various stakeholders might disagree on the effects of nonaudit services on auditor independence. Using responses from three groups of professional accountants (financial statement preparers) and bank loan officers (financial statement users), we extend auditor independence perception research to the post-Enron time period, finding a significant number of respondents perceiving non-audit services to impair auditor independence. We also find strong support for the self-serving bias

Research on Professional Responsibility and Ethics in Accounting, Volume 12, 173–202 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1574-0765/doi:10.1016/S1574-0765(07)00208-7

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argument, but limited support for the respondent knowledge argument, in explaining perceptual differences between groups. These results have important implications for regulators and standard-setters seeking to increase investor confidence in externally audited financial information by strengthening perceived auditor independence.

The debate over whether public accounting ﬁrms should supply non-audit services to their audit clients hinges on the proposition that providing such services impairs the auditor’s independence (Antle, 1984, p. 1).1 The Popular press (e.g., Moore, 2006) indicates that this issue is far from resolved, despite the Sarbanes–Oxley Act and subsequent regulations aimed to alleviate public concern. Auditor independence, with its dual-constructs of independence in appearance and independence in fact (e.g., AICPAs’ Code of Professional Conduct, 1988),2 have heightened the confusion surrounding the effects of non-audit services on auditor independence. This paper focuses on the debate surrounding the effects of non-audit services on the appearance (or perception) of independence.3 While many studies have addressed this issue, a sharp contrast in opinion remains as to what the results of these studies show. Reviewing 20 years of empirical research on the subject, Kinney (1999, p. 74) found ‘‘virtually no evidence that investors share the scope-of-services concerns of regulators.’’ Conversely, our review of the past 40 years of perception studies indicates a broad spectrum of stakeholders perceive that non-audit services tend to impair auditor independence, and that users of ﬁnancial statements may be even more concerned than preparers of such information about potential conﬂicts of interest. These perception studies, however, predate the collapse of Enron, which served as a catalyst to heighten the public debate surrounding the scope of non-audit services auditors may provide to their audit clients. This chapter extends the non-audit service auditor independence perception research to the post-Enron era, focusing on searching for evidence of why perceptions about the impact of non-audit services on auditor independence might differ between certain groups. Two explanations for perceptual differences have dominated public debates (e.g., Securities and Exchange Commission’s Hearings Testimony, 2000b, c, d, e) on this issue. The self-serving bias argument posits that economic rents auditors hope to receive from non-audit services align their interests with management, often unconsciously and unintentionally, thus biasing auditors and impairing their ability to make accurate assessments of the effects of non-audit services on

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their own independence.4,5 In contrast, the respondent knowledge argument proposes that those with greater audit role awareness correctly perceive less of an independence problem related to auditors’ provision of non-audit services to their audit clients. In this argument, relatively less informed observers, unaware of existing safeguards already in place to assure auditor independence (e.g., independence standards, litigation risks, loss of reputation) irrationally perceive that certain non-audit services impair independence, when, in fact, these services do not. While both arguments have been widely advanced, little research has tested empirically either argument or the comparative validity of these suppositions. This study is important because the arguments suggest divergent courses of action to restore the appearance of auditor independence, should it be impaired. The self-serving bias argument suggests that regulators and legislators should ban or further restrict the scope of non-audit services to assure auditor independence. This argument also questions the effectiveness of accounting professionals setting their own standards, given that self-interests blind auditors to the inherent conﬂict of interest. Conversely, if the respondent knowledge argument is valid, then recent legislation and standards proscribing non-audit services may be misdirected. Rather than ban these services, the appropriate action would be to correct the misinformation (i.e., educate uninformed observers about safeguards already in place that sufﬁciently assure auditor independence against the potentially biasing effects associated with non-audit services). To test the self-serving bias argument, we examine whether subjects’ perceptions of the effects of non-audit services on auditor independence are associated with their likelihood of receiving economic rents from providing such services. Subjects with higher potential to receive economic rents from non-audit services are expected to view them more favorably. To test the respondent knowledge argument, we examine whether subjects’ perceptions of these services is associated with their audit role awareness, with the expectation that those with higher audit role awareness would be least likely to perceive non-audit services impair auditor independence. The remainder of the chapter is organized as follows. First, we provide a brief background on auditor independence, non-audit services, and the self-serving bias and respondent knowledge arguments posited to explain perceptual differences regarding the effect of these services on auditor independence. Next, we describe our research design and methodology, followed by a presentation of the results, discussion, and conclusion.

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BACKGROUND AND HYPOTHESES Auditor Independence, Non-Audit Services, and the Importance of Perceptions Gaa (1992, p. 13) proposes that the principle of independence deﬁnes the role of the external auditor, because it is the only principle in the Code (AICPA, 1988 Professional Code of Conduct) that is unique to the auditor. Both the accounting profession and regulators require external auditors to be independent in appearance and in fact (AICPA, 1988, 1997; SEC, 2000a). While some have argued that independence in fact is what really matters (e.g., Elliott, 1992), the SEC (2000a, p. 1) has taken the position that the perception of independence is as important as fact. Investor conﬁdence ‘‘requires not only that auditors actually be independent of their audit clients, but also that reasonable investors perceive them to be independent’’ (SEC, 2000a, p. 1). The importance of non-audit services as a source of signiﬁcant fees to public accounting ﬁrms can be traced back to the mid-1950s (Previts, 1987, pp. 88–91). Shortly thereafter, accounting research questioned the compatibility of these services and auditing (see, e.g., Schulte, 1965, p. 587; 1966, p. 721), in particular their impact on auditor independence. In the decades preceding the collapse of Enron, public accounting ﬁrms experienced rapid growth in nonaudit services. Regulators (Public Oversight Board, 1979; SEC, 2000a, p. 1) became increasingly concerned that the growth in the percentage and magnitude of fees from non-audit services that auditors provided to their audit clients would impair auditor independence. By 1999, non-audit service fees for the Big Five accounting ﬁrms represented 50–70% of total ﬁrm revenues and were increasing at a faster rate than audit fees (SEC, 2000c, p. 14). In 2000, the SEC (2000f, Preliminary Note) revised their auditor independence guidelines, formally adopting four principles to guide regulators and auditors on decisions about the types of non-audit services that may impair auditor independence. Non-audit services provided by auditors to their audit clients potentially: 1. creates a mutual or conﬂicting interest between the accountant and the audit client; 2. places the accountant in the position of auditing his or her own work; 3. results in the accountant acting as management or an employee of the audit client; or 4. places the accountant in a position of being an advocate for the audit client.

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The SEC’s proposal also identiﬁed 10 non-audit services that could impair auditor independence. While only two of the proposed non-audit service prohibitions were new to the accounting profession, the ensuing debates around the SEC proposal were intense and acrimonious. In response to the SEC’s proposal, the then AICPA CEO Robert Elliott (SEC, 2000c, p. 105) stated, ‘‘the proposed rule points to a problem where none exists, so it can propose a solution where none is needed.’’ Kinney (1999, p. 74), the AICPA’s (1997, pp. 50–51) White Paper on the conceptual framework of auditor independence, and the American Accounting Association’s Financial Accounting Standards Committee (AAA FASC, 2001, pp. 380–383) similarly concluded that stakeholders’ perceptual concerns were largely unsubstantiated or non-existent. In contrast, Thornton’s (2003, pp. 46–47) review of the testimonies given at the SEC’s Independence Hearings ﬁnds that several important stakeholders testiﬁed they perceived that non-audit services impaired independence. Our review of the past 40 years of accounting research also indicates that there is at least a perception (independence in appearance) problem with respect to the provision of non-audit services by auditors to their audit clients. Several studies using survey and questionnaire methodologies to solicit responses from a broad spectrum of ﬁnancial statement user and preparer groups (e.g., Schulte, 1965, 1966; Briloff, 1966; Titard, 1971; Hartley & Ross, 1972; Lavin, 1976; Pany & Reckers, 1980, 1983, 1984, 1988; Firth, 1980, 1981; Shockley, 1981; Lowe, Geiger, & Pany, 1999; Hussey & Lan, 2001; Geiger, Lowe, & Pany, 2002) have generally concluded: (1) that a signiﬁcant proportion of users and preparers perceive that non-audit services tend to impair auditor independence,6 and (2) that users may be more concerned than even preparers about a loss of auditor independence when auditors provide non-audit services to their audit clients.7 The present chapter looks to extend non-audit services’ perceptual research to the post-Enron time period, with a particular interest in explanations given from stakeholders for their perceptions of the effects of these services on auditor independence.

The Self-Serving Bias Argument Two arguments have received the most attention as possible explanations for differing perspectives on non-audit services’ effects on auditor independence. The self-serving bias argument (Bazerman, Morgan, & Loewenstein, 1997, p. 89; King, 2002, p. 265; Moore, Tetlock, Tanlu, & Bazerman, 2006, p. 1)

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expects differences between user and preparer groups’ perceptions of nonaudit services’ effects on auditor independence due to differences in potential participation in economic rents. The generic self-serving bias argument posits that those called to make impartial judgments are likely to do so unconsciously, although biased in a manner commensurate with their own self-interests. Under this supposition, auditors may be precluded from correctly assessing their own independence. Bazerman et al. (1997, p. 90) argue that when ﬁnancial incentive arrangements (e.g., ‘‘auditors are hired, paid, and even ﬁred by the organizations they audit’’) tie auditors to their audit clients, auditors simply cannot maintain their independence. They further argue that bias frequently occurs without intent. Self-serving bias typically enters unconsciously and unintentionally at the stage of making – rather than reporting – judgments. Auditors aligning their self-interests with management may be incapable of issuing unbiased reports. This powerful descriptive supposition, grounded in ethical egoism,8 suggests auditors will be less likely to perceive non-audit services as impairing auditor independence than will other stakeholders, due to their interests in the economic rents they hope to receive from non-audit services. The self-serving bias argument predicts that those with the highest level of economic interest in non-audit services will be least likely to perceive these services as impairing auditor independence. The self-serving bias hypothesis, stated in alternate form, is: H1. Respondents receiving higher economic rents from non-audit services are less likely to perceive that non-audit service fees compromise auditor independence than respondents receiving lower economic rents. Empirical evidence supporting the self-serving bias argument in an audit context would have important policy implications, such as proscribing certain non-audit services necessary to assure the appearance of auditor independence. While many CPA ﬁrms, including three of the Big Four ﬁrms, recently divested their consulting arms, in part due to the SEC’s revision of its auditor independence rules and the Sarbanes–Oxley Act (2002), the economic rents from other non-audit services (e.g., tax services) that CPA ﬁrms receive remain sizeable and continue to attract regulatory attention (Arens, Elder, & Beasley, 2006, pp. 27–28). Evidence of self-serving bias would also have important educational implications, such as educating current and future auditors about this subconscious bias9; but if no evidence exists of self-serving bias, banning valuable non-audit services may be detrimental to corporations and the public, since clearly there is a strong demand for the accounting ﬁrms’ non-audit services.

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The Respondent Knowledge Argument A second argument, which we call the respondent knowledge argument based on Pany and Reckers’ (1984, pp. 91–92) study, appears throughout the literature as an ad hoc explanation of researchers’ ﬁndings of between-group differences in perceptions of non-audit services’ effects on auditor independence. Originally proposed over 30 years ago (Titard, 1971, p. 51) and often cited in regulatory debates under various names (e.g., ‘‘in-groups’’ vs. ‘‘out-groups’’ AAA FASC, 2001, pp. 380–381), this argument proposes that knowledge differences between respondent groups, rather than economic interests, explain why certain groups are more likely to perceive that nonaudit services impair auditor independence. Auditors are less concerned about non-audit services impairing auditor independence because they are relatively more aware of the safeguards implemented by AICPA and SEC standards to ensure independence. An independent-in-fact auditor may be incorrectly perceived as not independent when observers’ perceptions are not fully informed (see AAA FASC, 2001, p. 383). Implicit in the respondent knowledge argument is the notion that perceptions of the less knowledgeable person need to change. This implication is important, since normatively users’ interests supersede preparers’ interests,10 especially lacking a rational reason to act otherwise. The respondent knowledge argument is posited to be a rational reason to act otherwise. Pany and Reckers (1984) performed the only study, to our knowledge, that investigated the respondent knowledge argument as it relates to nonaudit services. Using two groups of ﬁnancial statement users – stockholders and Chartered Financial Analysts (CFAs) – they found no support for the contention that those with low audit role awareness are most concerned about a possible lack of auditor independence. The present chapter reexamines the respondent knowledge argument’s prediction that those with the highest audit role awareness will be less likely to perceive non-audit service fees compromising auditor independence, because they are aware of the importance of independence to the accounting profession and the safeguards in place to mitigate the risk of impaired independence. The respondent knowledge hypothesis, stated in alternate form, is: H2. Respondents with high audit role awareness are less likely to perceive that non-audit service fees compromise auditor independence than respondents with low audit role awareness. This hypothesis is important since the validity of the respondent knowledge argument has important public policy implications that contrast

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with those of the self-serving bias argument. Empirical evidence supporting the argument would indicate that educating ﬁnancial statement users regarding current safeguards in place to protect against impaired independence will increase users’ perception of auditor independence. Conversely, a lack of evidence supporting the hypothesis suggests that the accounting profession’s primary defense for over 30 years for providing fee-based nonaudit services to their audit clients may be unjustiﬁed. Taken together, the above two hypotheses are important to legislators, regulators, and the profession as they seek to ensure that auditors appear independent to all stakeholders. Moreover, since prior studies have shown that jurors (Lowe, 1992) and judges (Anderson, Jennings, & Reckers, 1993, p. 462; Lowe, 1994, p. 39) perceive auditors as less independent than auditors perceive themselves, understanding these differences is important to the accounting profession from a litigation standpoint.

RESEARCH DESIGN AND METHOD Participants To test our hypotheses, we collected survey data from four targeted groups in a large metropolitan area, including one ﬁnancial statement user group (bankers) and three preparer groups (professional accountants) with theorized increasing levels of interest in the economic rents from non-audit services.11 The user group contained 31 bank executives and senior loan ofﬁcers from 7 large area banks. Bank executives and loan ofﬁcers are generally deemed to be reasonably informed ﬁnancial statement users (see, e.g., Geiger et al., 2002, p. 22; Lowe et al., 1999, p. 12),12 and are expected to have the lowest interest in economic rents from non-audit services provided to audit clients. Preparer groups consisted of three groups of professional accountants, including 103 professional accountants working in industry, 170 professional accountants performing non-audit work for public accounting ﬁrms, and 118 auditors currently performing audit work for public accounting ﬁrms, with each group expected to have increasing interest in economic rents available from the provision of non-audit services to audit clients. One of the authors administered the surveys in a large metropolitan area to targeted groups attending professional meetings (e.g., annual Continuing Professional Education (CPE) meetings for the Tax Executive Institute, Financial Executive Institute, Institute of Management Accountants, and an

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annual CPE day for a Fortune 100 company) and to a group of public auditors for a Big Four accounting ﬁrm. Essentially, all meeting participants completed the survey, greatly mitigating non-response bias.13 The surveys were administered in 2002 and 2003, subsequent to Enron’s collapse, but prior to the PCAOB’s (2006, p. 6) new regulations limiting the scope of tax services auditors can provide their audit clients. Survey Instrument A survey instrument was constructed to elicit subjects’ perceptions of auditors’ independence when auditors provide non-audit services and receive non-audit fees, including their perceptions of the effects of 13 different nonaudit services on auditor independence and judgment. Subjects also expressed their level of agreement (1 is ‘‘strongly disagree,’’ 7 is ‘‘strongly agree,’’ and 4 is ‘‘neither agree nor disagree’’) with several statements on the effects of large public accounting ﬁrms’ consulting engagements on clients’ ﬁnancial power over their independent auditor, and whether large accounting ﬁrms have been ‘‘completely independent’’ in appearance and in fact. The data collected helped develop several independent and dependent measures, described below, to test the self-serving bias and respondent knowledge arguments. Independent Variables Relative Economic Rents To test the self-serving bias argument, we classify subjects into one of the four following groups (RENTGRP) hypothesized to have successively diminishing claims to the economic rents from non-audit services: 1. auditors in public practice (i.e., public accounting: audit); 2. professional accountants in public practice not providing audit services (i.e., public accounting: other); 3. professional accountants, both CPAs and non-CPAs, outside of public accounting (i.e., industry accountants); and 4. bank executives and loan ofﬁcers, as surrogates for informed users of the ﬁnancial statements (i.e., bankers). Among these groups, auditors in public practice are expected to have the greatest interest in economic rents from non-audit services as the audit function affords them the opportunity to cross-sell non-audit services while performing audits (SEC, 2000a). Professional accountants in public

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accounting uninvolved in the audit function still beneﬁt from their ﬁrms’ non-audit services through fee sharing and off-peak season workloads. Professional accountants outside of public accounting potentially beneﬁt indirectly, such as through increased demand for accountants’ services or their company’s consumption of non-audit services at lower costs, while users of ﬁnancial statements receive neither direct nor indirect economic rents from auditors providing non-audit services to their clients. As an alternate measure of respondents’ expectations of receiving economic rents associated with non-audit services, we distinguished owners of CPA ﬁrms (RENTOWNER) from all other respondents as having relatively higher interests in such economic rents. We determine audit ﬁrm ownership using respondent answers to the open-ended question, ‘‘What is your current title?’’ coupled with those identifying themselves as working in public accounting. Ownership titles included partner, principal, owner, shareholder, sole proprietor, directors/managing directors, president or CEO. Respondent Knowledge We used two different measures of audit role awareness to test the respondent knowledge argument. The AICPA, SEC, and PCAOB have identiﬁed certain non-audit services with a high likelihood of compromising auditor independence (e.g., asset valuation) compared to other services that are deemed to have a low likelihood of impairing auditor independence (e.g., tax compliance). Our ﬁrst measure (KNOWARA) used these areas of consensus in the authoritative literature to classify respondents’ audit role awareness into low, medium, and high levels of knowledge based on their responses to the following question: Which of the following audit ﬁrm services, if contracted with the auditor’s ﬁrm by the client, would tend to compromise the auditor’s independence and judgment?

Subjects correctly identifying asset valuation as tending to compromise independence and correctly identifying tax compliance as tending not to compromise independence were categorized as having high audit role awareness.14 Those answering the opposite were categorized with low audit role awareness, and those who answered neither or both services compromised auditor independence were categorized with moderate audit role awareness (Exhibit 1).15 As an alternate measure of audit role awareness (KNOWCPA), we distinguish between CPAs (higher audit role awareness) and non-CPAs (lower audit role awareness), based on the certiﬁcation education requirements. To pass the CPA exam, accounting professionals must demonstrate

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Dependent Variables INDEPEND = 1 if auditor is perceived to be independent, 0 if not perceived to be independent. Response to the question: Auditors accepting non-audit fees will likely compromise their independence? 0 if “yes” (i.e. not independent); 1 if “no” (i.e. independent); excluded from analyses if “don’t know.” INDEPSUB = Given consulting engagements, auditors subordinate their judgment (1 = strongly disagree, 7 = strongly agree, and 4 = neither agree or disagree). INDEPAPP = Given consulting engagements, auditors have been completely independent in appearance (1–7). INDEPFACT = Given consulting engagements, auditors have been completely independent in fact (1–7). AUDQUAL = Principle component analysis combing four audit quality questions (1–7). Independent Variables Respondent Knowledge Variables KNOWARA = 3 if high, 2 if medium, 1 if low audit role awareness. High: Asset valuation compromises and tax compliance does not compromise independence. Low: Asset valuation does not compromise and tax compliance compromises independence. Medium: Both asset valuation and tax compliance compromise independence or neither asset valuation nor tax compliance compromise independence. KNOWCPA = 1 if CPA, 0 if not a CPA. Relative Economic Rents Variables RENTGRP = 4 if public accounting: audit, 3 if public accounting: other, 2 if industry accountant, and 1 if bank executive/loan officer RENTOWNER = 1 if CPA firm owner, 0 if other Control Variables DEGCAT = 1 if higher than a Bachelor’s degree, 0 if other GENDER = 1 if female, 0 if male

Exhibit 1.

Dependent, Independent, and Control Variables.

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knowledge of the AICPA’s Code of Professional Conduct (1988), whose principles and rules state clearly the importance of maintaining independence in appearance and in fact on all attest engagements. Most state boards of accountancy also require CPAs to obtain continuing education in professional ethics. Ceteris paribus, CPAs are expected to have a relatively higher awareness of the inﬂuences that might impair an auditor’s independence than those who have not obtained certiﬁcation.16

Dependent Variable Perceived Independence To measure perceived independence (INDEPEND), we created a dichotomous variable (1 if perceived independent; 0 if not) based on subjects’ responses to the following question: ‘‘Auditors accepting non-audit fees will likely compromise their independence?’’17 Consistent with most prior studies, the present study does not deﬁne independence initially.18 However, to ensure that our results are generalizable across a broad range of auditor independence deﬁnitions, in the second part of our survey, we collect information to construct three additional measures of auditor independence to capture important perspectives of independence that Hartley and Ross (1972, p. 51) identify. Their study provides one of the most robust deﬁnitions of auditor independence, consisting of (1) a sense of being self-reliant and not subordinate to the judgment of the client, (2) being in fact objective and free from bias, and (3) having the appearance of independence from a reasonably informed investor perspective. To test for subordinating professional judgment (INDEPSUB), we ask subjects to indicate their level of agreement (1 ¼ strongly disagree, 7 ¼ strongly agree, and 4 ¼ neither agree nor disagree) with the following statement: ‘‘Large accounting ﬁrms’ consulting engagements increase clients’ ﬁnancial power over their independent auditors.’’ To test for independence in appearance (INDEPAPP) and independence in fact (INDEPFACT), we ask subjects to indicate their level of agreement with the statements ‘‘Such large accounting ﬁrms have been completely independent in appearance’’ and ‘‘y in fact,’’ respectively. Independence is also important to the audit function primarily from its effect on audit quality, which has been conceptualized as a function of auditor independence and expertise (AAA FASC, 2001, p. 382). Opponents (e.g., Melancon, 2000, p. 27) of non-audit service scope restrictions argue that limiting non-audit services harms overall audit quality, raises clients’

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audit fees, and limits the quality of auditors’ recommendations for improving operational effectiveness. To test for the perception of adverse audit quality effects, we ask subjects to indicate their level of agreement (on a scale of 1–7) on the following multiple part statement: ‘‘Management consulting services help auditors: (a) better understand their client, (b) perform better audits, (c) make better recommendations that improve their clients’ operational effectiveness, and (d) lower their clients’ audit fees.’’ We tested the internal reliability of these combined items using the coefﬁcient alpha reliability index (Cronbach, 1951, p. 307). The coefﬁcient alpha reliability estimate for this perceived audit quality variable (AUDQUAL) is .70, a generally accepted value (Nunnally, 1978, p. 245). Control Variables We also collected data on two common sociological control variables, level of education (DEGCAT) and gender (GENDER).

RESULTS Descriptive Statistics Table 1 summarizes the descriptive statistics for the independent and dependent variables. Panels A and B, respectively, sort the data by economic rent group (RENTGRP) and by audit role awareness (KNOWARA). Panel A (last column) shows that overall, 214 (51%) perceive that auditors maintain their independence when non-audit service fees arise.19 The proportion of subjects that perceive auditors as independent (INDEPEND) declines with economic rents (RENTGRP), from 77% of auditors in public accounting to 54% of others in public accounting to 25% of industry accountants to 19% of bankers. Panel B (last column) shows that the relationship between audit role awareness (KNOWARA) and INDEPEND is not as obvious, with 44% of those with high audit role awareness, 58% of those with medium audit role awareness, and 18% of those with low audit role awareness perceiving auditors to be independent when they provide non-audit services. The relatively small number of subjects with low audit role awareness (17) is consistent with the relatively high proportion of subjects with professional certiﬁcations, advanced degrees, and a high level of experience. CPAs comprised 85% of the public accounting audit group, 86% of the public accounting other group, and 69% of industry accountants. Also, 68% of the public accounting audit group and 53% of the public accounting other

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Table 1. RENTGRP

Basic Statistics of Variables.

Number (%a) of Subjects

KNOWCPA

RENTOWNER

INDEPEND

Percent CPAs

Percent owners

Percent independent

Panel A: Data sorted by economic rent group category Public accounting: audit Public accounting: other Industry accountants Bankers Total subjects Percent of total subjects KNOWARA

118 (28%) 170 (40%) 103 (24%) 31 (7%) 422 100%

85% 86% 69% 0% 318 75%

68% 53% 1% 0% 171 40%

77% 54% 25% 19% 214 51%

Number (%) of Subjects

KNOWCPA

RENTOWNER

INDEPEND

Percent CPAs

Percent owners

Percent independent

36% 61% 3% 171 40%

44% 58% 18% 214 51%

Panel B: Data sorted by audit role awareness category High awareness Medium awareness Low awareness Total subjects Percent of total subjects a

170 (40%) 235 (56%) 17 (4%) 422 100%

43% 54% 3% 318 75%

All percentages rounded to the nearest percent.

group were owners, indicating a high level of experience among public accounting subjects. Many subjects also held graduate degrees (34% of professional accountants and 35% of bankers) and an even higher percentage were male (72% of the professional accountants and 74% of the bank ofﬁcers and executives). The under-representation of female participants in our sample is consistent with realities in senior levels of banking and accounting.

Univariate Tests Table 2 shows univariate correlations between the key variables.20 As predicted by the self-serving bias argument, INDEPEND signiﬁcantly and positively relates to RENTGRP (.406, po.001), indicating that as economic beneﬁts to the subject groups increase, perceived independence increases. This observation is also supported with the signiﬁcant positive relationship

INDEPEND

KNOWARA

KNOWCPA

RENTGRP

RENTOWNER

Pearson Correlations of Primary Independent and Dependent Variables.

Pearson correlation Signiﬁcance (two-tailed) N Pearson correlation Signiﬁcance (two-tailed) N Pearson correlation Signiﬁcance (two-tailed) N Pearson correlation Signiﬁcance (two-tailed) N Pearson correlation Signiﬁcance (two-tailed) N

INDEPEND

KNOWARA

KNOWCPA

RENTGRP

RENTOWNER

1 . 422 .047 .331 422 .239** .000 422 .406** .000 422 .370 ** .000 422

1 . 422 .105* .030 422 .028 .564 422 .043 .376 422

1 . 422 .395** .000 422 .405** .000 422

1 . 422 .527** .000 422

1 . 422

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Table 2.

*Correlation is signiﬁcant at the .05 level. **Correlation is signiﬁcant at the .01 level.

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between INDEPEND and owners of CPA ﬁrms (RENTOWNER), our second measure for economic rents (.370, po.001). Contrary to the respondent knowledge argument, INDEPEND is not signiﬁcantly correlated with the audit role awareness measure KNOWARA (.047, p ¼ .331). In a simple univariate sense, we have no indication that our primary measure of audit role awareness affects subjects’ perception of independence. Our alternate measure of respondent knowledge, the CPA designation variable (KNOWCPA), signiﬁcantly and positively relates to INDEPEND (.239, po.001). However, KNOWCPA is also signiﬁcantly and positively related to other independent variables representing economic rents (e.g., RENTGRP: .395, po.001; RENTOWNER: .405, po.001). Thus, the relationship between INDEPEND and KNOWCPA is unclear. We explore this relationship further in the multivariate analysis below. Multivariate Tests The basic logistic regression model, Model 1 : INDEPEND ¼ f ðRENTGRP; RENTOWNER; KNOWARA; KNOWCPA,GENDER; DEGCATÞ is shown in Table 3, Panel A. Results indicate that the logistic regression model is highly signiﬁcant (w2 ¼ 94.2, po.001). As predicted by self-serving bias, each of the model’s self-serving bias variables positively and signiﬁcantly (RENTGRP: b ¼ .682, po.001; RENTOWNER: b ¼ .936, p ¼ .001) impact INDEPEND, indicating that respondents’ perceptions of auditor independence increases with group economic rents and ownership interests. Conversely, neither respondent knowledge variable is consistent with the argument’s expectations. KNOWARA lacks signiﬁcance, and is in the opposite direction predicted by the respondent knowledge argument (b ¼ .252, p ¼ .220). KNOWCPA is in the predicted direction, but lacks signiﬁcance when controlling for the economic rent variables (b ¼ .475, p ¼ .104). Additional Tests Inspecting Table 1, Panel B, reveals that subjects in the medium audit role awareness group are least concerned about non-audit services’ effects on auditor independence. Subsequent analyses reexamined our hypotheses, using the full logistic regression model on the reduced sample, omitting

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Table 3. Model w2 ¼ 94.2 (po.001)

189

Full Logistic Regression Model with Full and Reduced Samples. b

p-Value (Two-Tailed)

df

Panel A: Full logistic regression model with full sample INDEPEND=f(RENTGRP, RENTOWNER, KNOWARA, KNOWCPA, GENDER, DEGCAT) RENTGRP RENTOWNER KNOWARA KNOWCPA GENDER DEGCAT Constant Model w2 ¼ 44.9 (po.001)

.682 .936 .252 .475 .444 .268 2.085 b

1 1 1 1 1 1 1

.000 .001 .220 .104 .091 .290 .003 p-Value (Two-Tailed)

df a

Panel B: Full logistic regression model with reduced sample INDEPEND=f(RENTGRP, RENTOWNER, KNOWARA, KNOWCPA, GENDER, DEGCAT) RENTGRP RENTOWNER KNOWARA KNOWCPA GENDER DEGCAT Constant a

.902 .948 .404 .825 .855 .280 5.457

1 1 1 1 1 1 1

.001 .033 .276 .100 .040 .502 .000

Reduced sample: Medium audit role awareness subjects are omitted.

medium audit role awareness subjects (see Table 3, Panel B) derives much signiﬁcance (w2 ¼ 44.9, po.001), with RENTGRP and RENTOWNER remaining signiﬁcant (p ¼ .001 and .033, respectively). KNOWARA is not signiﬁcant (p ¼ .276), though in the hypothesized direction. KNOWCPA is marginally signiﬁcant (p ¼ .100). In additional tests (see Table 4), we alternate economic rent variables (RENTGRP, RENTOWNER) and audit role awareness variables (KNOWARA, KNOWCPA) to test the competing hypotheses, resulting in four crossed logistic regression models. In each model, the economic rent variables are highly signiﬁcant (po.001). KNOWARA is not signiﬁcant in any model, while KNOWCPA is signiﬁcant and positive (po.05) in each model where only one economic rent variable is included. DEGCAT is also negative in all models, and at least moderately signiﬁcant (po.10) in three of the four crossed models, indicating that those with graduate degrees are more likely to perceive an independence problem than others.

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Table 4. Logistic Regression for Crossed Models (1–4). Model w2 ¼ 76.6 (po.001)

b

df

p-Value (Two-Tailed)

Panel A: Model 1 INDEPEND=f(RENTGRP, KNOWARA, GENDER, DEGCAT) RENTGRP KNOWARA GENDER DEGCAT Constant

.975 .203 .085 .381 2.166

Model w2 ¼ 68.4 (po.001)

b

1 1 1 1 1

.000 .308 .727 .117 .001

df

p-Value (Two-Tailed)

Panel B: Model 2 INDEPEND=f(RENTOWNER, KNOWARA, GENDER DEGCAT) RENTOWNER KNOWARA GENDER DEGCAT Constant Model w2 ¼ 81.2 (po.001)

1.601 .214 .465 .507 .005

1 1 1 1 1

.000 .277 .064 .031 .992

b

df

p-Value (Two-Tailed)

Panel C: Model 3 INDEPEND=f(RENTGRP, KNOWCPA, GENDER, DEGCAT) RENTGRP KNOWCPA GENDER DEGCAT Constant Model w2 ¼ 73.1 (po.001)

.884 .668 .169 .425 2.920

1 1 1 1 1

.000 .019 .494 .083 .000

b

df

p-Value (Two-Tailed)

Panel D: Model 4 INDEPEND=f(RENTOWNER, KNOWCPA, GENDER, DEGCAT) RENTOWNER KNOWCPA GENDER DEGCAT Constant

1.388 .657 .488 .565 .916

1 1 1 1 1

.000 .017 .055 .017 .001

Alternate Definitions of Independence and Audit Quality We also performed various ANOVA tests (Table 5), using three different dependent variables to capture unique deﬁnitions of auditor independence (INDEPSUB ¼ subordinating independent judgments to management;

Model

R2

Adjusted R2

Other Perceived Independence Variables.

F

RENTGRP

RENTOWNER

KNOWARA

KNOWCPA

GENDER

DEGCAT

Constant

p-values

p-values

p-values

p-values

p-values

p-values

p-values

p-values

.526 .000 –

–

–

.251 .139 .307 .093 .181 .290 2.78 .132 .212 .231

.022 .897 .195 .267 .001 .996 .241 .172 .041 .816

5.756 .000 4.307 .000 6.588 .000 5.164 .000 5.751 .000

INDEPSUB subordinating to the client 1 .11 .10 12.051 .000 2 .05 .04 4.863 .001 3 .10 .09 11.058 .000 4 .03 .02 2.919 .021 5 .12 .10 8.576 .000

.608 .000 – .590 .000

–

.361 .010

.408 .037 .132 .513 .348 .084

–

–

–

–

–

–

–

–

–

–

–

–

–

–

–

–

–

–

–

–

–

–

–

–

.333 .051

.417 .094

.119 .578

5.519 .000

.457 .017 .011 .955

.438 .072

–

.178 .408

191

INDEPAPP independence in appearance 1 .02 .01 1.955 – .101 2 .01 .00 1.382 – .239 3 .01 .00 1.380 – .240 4 .02 .01 1.693 – .151 5 .03 .02 2.128 .204 .049 .119

.413 .020 –

.392 .005 .406 .005 –

Impact on Auditor Independence

Table 5.

192

Table 5. (Continued ) Model

R2

Adjusted R2

RENTGRP

RENTOWNER

KNOWARA

KNOWCPA

GENDER

DEGCAT

Constant

p-values

p-values

p-values

p-values

p-values

p-values

p-values

p-values

–

.126 .380 .138 .343 –

–

.303 .086 .441 .018 .280 .115 .430 .021 .382 .040

.112 .532 .174 .328 .120 .502 .189 .286 .050 .783

2.554 .000 3.421 .000 2.283 .000 3.137 .000 2.634 .000

.055 .655 .082 .534 .019 .877 .071 .586 .026 .838

.208 .095 .352 .006 .210 .091 .365 .004 .199 .117

3.886 .000 4.830 .000 3.658 .000 4.586 .000 3.888 .000

INDEPFACT independence in fact 1 .06 .05 5.924 .000 2 .05 .04 4.573 .001 3 .06 .05 5.826 .000 4 .04 .03 4.357 .002 5 .07 .05 4.501 .000 AQUAL audit quality 1 .10 .09 2

.05

.04

3

.11

.10

4

.05

.04

5

.11

.10

10.823 .000 4.976 .001 11.395 .000 4.666 .001 7.739 .000

.376 .000 – .403 .000 – .323 .004 .342 .000 – .393 .000 – .389 .000

.575 .001 – .595 .002 .355 .087 – .257 .045 – .286 .038 .000 .998

– .113 .435 .123 .222 .129 .213 – – .100 .324

– .129 .525 .056 .782 .192 .361 – – .264 .060 .088 .540 .246 .091

JOHN M. THORNTON ET AL.

F

Impact on Auditor Independence

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INDEPFACT ¼ independent in fact; INDEPAPP ¼ independent in appearance), and also a dependent variable (AUDQUAL) to measure for audit quality. INDEPSUB ANOVA (Adjusted R2 ¼ .10, po.001), INDEPFACT ANOVA (Adjusted R2 ¼ .05, po.001), and AUDQUAL ANOVA (Adjusted R2 ¼ .10, po.001) are all highly signiﬁcant, with the economic rent variables RENTGRP, RENTOWNER, or both highly signiﬁcant (generally W.01). Only in the INDEPAPP (independence in appearance) ANOVA (Adjusted R2 ¼ .02, p ¼ .049) did the economic rent variables fail to be highly signiﬁcant, and even then, RENTOWNER remained marginally signiﬁcant (p ¼ .072). Conversely, the audit role awareness variable KNOWARA is often opposite the direction that respondent knowledge hypothesized, and KNOWCPA is generally in the opposite direction in our ANOVA tests, after controlling for the economic rent variables.

DISCUSSION AND CONCLUSIONS This study examines the effects of public accounting ﬁrms’ provision of nonaudit services to their audit clients on the perception (or appearance) of auditor independence. Extending prior research to the post-Enron time period, we ﬁnd about half of all respondents perceive non-audit services to impair auditor independence. This ﬁnding conﬁrms our review of early perception studies, and questions various stakeholders’ claim that no perception problem exists. This is the ﬁrst study to classify professional accountants into groups with differing interests in the economic rents from non-audit services, and combined with survey responses from bank executives and loan ofﬁcers allows us to test two competing arguments – self-serving bias and respondent knowledge – given for differences in perceptions of the effects of non-audit services on auditor independence. Our investigation ﬁnds strong support for self-serving bias, but weak support, at best, for respondent knowledge. Speciﬁcally, subjects’ perceptions of non-audit services’ effects on auditor independence correlate highly with their respective interests in the economic rents from providing those services. This ﬁnding is consistent across multiple measures of economic rents, dichotomous and scaled measures of auditor independence, and various deﬁnitions of auditor independence and audit quality. The results also remain signiﬁcant after controlling for subjects’ level of audit role awareness, gender, and level of education. Regarding the respondent knowledge argument, subjects’ audit role awareness is not correlated with their perceptions of the effects of non-audit

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services and fees on auditor independence. In fact, audit role awareness is not signiﬁcant in any of our logistic regression models, a result remaining consistent across deﬁnitions of auditor independence, and for a reduced sample excluding subjects with a medium-level of audit role awareness. Additional tests of the respondent knowledge argument using CPAs (nonCPAs) as surrogates for a high (low) level of audit role awareness provide limited support for the respondent knowledge argument, in that CPAs are more likely to view auditors as independent when they provide non-audit services to audit clients. However, even this measure of audit role awareness does not remain signiﬁcant when controls for economic rents are added to the model. These results are consistent with Pany and Reckers’ (1984, p. 93) study that found no support for the respondent knowledge argument. We extend their ﬁndings by using new measures of audit role awareness, and by increasing the scope of participants to include both ﬁnancial statement users and three classes of professional accountants. We also extend their ﬁndings to the post-Enron, post-SEC independence rule era. Taken together, these results have important public policy implications. First, professional accountants, from those involved in the attest function to those buying non-audit services, need further education as to the existence and nature of the self-serving bias. The bias is by nature unintentional (i.e., no intent is necessary) and may enter an audit unconsciously at the judgment-making stage. Accordingly, the self-serving bias issue is not necessarily an ‘‘integrity issue.’’ While many professional accountants acknowledge that a gap exists between their perceptions and the public’s perceptions regarding auditor independence and non-audit services, they have generally presumed that ﬁnancial statement users had the ‘‘wrong’’ perspective (e.g., ‘‘the observer’s perceptions are not fully informed,’’ AAA FASC, 2001, p. 383). Our results indicate that auditors, rather than the public, may need to change their perspectives. Second, since intent is not necessary for the self-serving bias to exist (Bazerman et al., 1997, p. 89), regulators and standard setters must evaluate the source of the economic rents and restrict non-audit services that impair auditor independence. The SEC (2000f, Preamble) has developed a principled approach to evaluate non-audit services that could impair independence, which should prove useful in developing meaningful and logically consistent regulations. The PCAOB (2005, Summary) recently used this approach to set new guidelines on tax services audit ﬁrms can provide to their audit clients. Still, prior research has shown both ﬁnancial statement users and preparers maintain divergent views on what services impair independence. Accordingly, proscribing certain non-audit services while

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allowing others may prove insufﬁcient to assure auditor independence. One possibility, favored among users testifying at the SEC’s Independence Hearings, is to draw a ‘‘bright line,’’ proscribing all non-audit services that auditors provide to the audit clients (see Thornton, 2003, p. 46). This approach would eliminate all economic rents from non-audit services, and thus remove any self-serving bias arising from undetected self-interests. However, it may also eliminate, or increase the costs of, many services that corporations legitimately need and value. Also, non-audit service fees are only a subset of the fees auditors receive from their audit clients (the most notable being the audit fees themselves), and may only serve to shift the selfserving bias argument from non-audit service fees to other areas (see, e.g., Moore, 2006). There are several limitations to our study. First, our measures of economic rents are indirect, predicated on assumptions about classes of individuals and their expectations of participation in non-audit service fees from audit clients. While we deem these assumptions rational, and results remain consistent across both of our measures of economic rents, future research should measure respondents’ actual and expected economic rents from nonaudit services directly, both in magnitude and percentage of non-audit service fees to total fees.21 Future studies should similarly consider alternate measures of audit role awareness. The present study’s use of CPAs as a surrogate for audit role awareness is subject to multicollinearity with the economic rent variables. Moreover, the direct measure of audit role awareness required respondents to have a very thorough knowledge of SEC and AICPA non-audit service principles and guidelines, and the moderate level of audit role awareness is subject to multiple interpretations. While our subsequent statistical analyses indicated that audit role awareness had no signiﬁcant effect on perceived auditor independence, even when moderate respondents were omitted, future research should develop other direct measures of respondent knowledge, including respondents’ knowledge of safeguards currently in place to assure auditor independence when non-audit services are provided. Our subjects were not selected randomly from a population of all professional accountants, and only one user group was included, which could impair the generalizability of this study’s ﬁndings to other professional accountants or user groups. All respondents were from a large metropolitan area that may be unrepresentative of geographic regions outside this area, and may not reﬂect the position of those outside that area. Future research should include additional user groups, and determine how regulators and standard setters could mitigate the self-serving bias through methods other

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than scope of service proscriptions. The accounting profession and regulators would beneﬁt from evidence about which non-audit services do and do not impair auditor independence. Like other survey research, the present study contains the usual limitations associated with non-experimental perceptual studies, and future research using case studies to manipulate key variables (e.g., economic rents) would be useful. Nonetheless, we believe our study provides strong support for self-serving bias over respondent knowledge to help explain differences in perspectives regarding the effects of non-audit services on auditor independence.

NOTES 1. All references to auditor independence in the present chapter refer exclusively to the external audit. 2. See Previts (1987, pp. 66–72) for a history of the debate about the deﬁnition of auditor independence. 3. The SEC (2000a, p. 1) considers both constructs equally important in assuring conﬁdence in the capital markets. Several studies subsequent to Enron’s collapse have addressed independence in fact (e.g., Frankel, Johnson, & Nelson, 2002, p. 71; Ashbaugh, LaFond, & Mayhew, 2003, p. 611; Reynolds, Deis, & Francis, 2004, p. 29). 4. In this chapter, economic rents refer to all actual and potential monetary incentives an individual might hope to receive from the public accounting profession’s provision of non-audit services to audit clients. The scope of economic rents range from direct participation in fee sharing agreements within an audit ﬁrm, to indirect expectations of participation in future fees from a client, individual promotion within the ﬁrm, to the potential of participating in fees due to growth in the public accounting profession as a whole. 5. The self-serving bias argument can also be extended beyond ﬁnancial incentives to non-ﬁnancial (e.g., relational, familial) incentives. 6. One exception was Briloff’s (1966, p. 484) preparer group respondents, where none of 22 Big Eight accountants believed management advisory services would detract from the auditor’s opinion (vs. 53% of the ﬁnancial community). 7. An exception to this general ﬁnding, Lavin (1976, p. 47) found CPAs perceived more independence problems more frequently (in 7 of 12 scenarios) than users (loan ofﬁcers and ﬁnancial analysts). 8. Ethical egoism theorizes that people always act in their own self-interest. This descriptive theory contrasts with its normative counterpart, psychological egoism, which states that people should always act in their own self-interest. 9. Our limited review of two popular student audit texts (Messier, Glover, & Prawitt, 2006; Arens et al., 2006) found no mention of the self-serving bias. 10. User primacy (Gaa, 1986, pp. 440–448) calls for a systematic bias in ﬁnancial reporting in favor of users of ﬁnancial statements who are in disadvantageous positions regarding the production and consumption of ﬁnancial information (Beaver & Demski, 1974, p. 178). User primacy is a foundational theory for the

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FASB’s Statement of Financial Accounting Concepts No. 1 (1990) and the AICPA’s Code of Professional Conduct (1988) which requires its members to put users’ interests ahead of their own when the two conﬂict. 11. While 536 subjects completed the survey, only 422 respondents in our study’s target groups (i.e., bankers and professional accountants) completed all the necessary information. Tests on demographic data show no signiﬁcant differences between the 114 dropped respondents and the 422 included respondents. 12. Our review of over 30 perception studies found bankers as the most frequently used group of surrogates for informed ﬁnancial statement users. 13. In our review of earlier non-audit services perception studies, non-response bias is a frequently cited limitation. 14. Despite the vigorous debate of the appropriateness of any auditor-provided non-audit service to their audit clients (e.g., SEC Independence Hearings, 2000b, c, d, e), the accounting profession and regulators’ positions on these two services have remained unchanged for the last 20 years. For example, the PCAOB’s (2004, p. 7) exposure draft on tax services states, ‘‘the SEC made it clear that it did not consider conventional tax compliance y to be a threat to auditor independence.’’ Concurrently, the AICPA and SEC have long banned auditor asset valuation services. 15. We recognize our potential limitation in identifying audit role awareness. Subjects who legitimately perceive all services or no services as impairing independence are classiﬁed as moderate levels of audit role awareness, a potentially invalid classiﬁcation because either of these groups may have theoretically sound arguments for their positions. However, we are unable to distinguish between respondents proscribing all services or no services in a rational manner from those whose responses lacked understanding, or simply had an ‘‘agenda.’’ In addition, we are more conﬁdent of our ‘‘low audit role awareness’’ categorization, since it is difﬁcult to imagine a theoretically consistent argument that would both support asset valuation and deny tax compliance services. 16. To the extent that public accounting ﬁrms are more likely than industry to employ individuals who have passed the CPA exam, the KNOWCPA variable may be limited by its signiﬁcant correlation with our economic rent variables discussed above. 17. As noted in the Participants section, subjects answering this question as ‘‘don’t know’’ were excluded from the analyses since we cannot interpret clearly whether independence is compromised. 18. Researchers (e.g., Pany & Reckers, 1983; Hussey & Lan, 2001; Hodge, 2003) have generally refrained from deﬁning auditor independence, consistent with the term not being deﬁned authoritatively in either the professional or regulatory literature. Previts’ (1987, pp. 80–88) comprehensive monograph on auditor independence discusses the highly divergent concepts, deﬁnitions, and interpretations of the term ‘‘auditor independence’’ used by the accounting profession and regulators. 19. All percentages are rounded to the closest integer. 20. Correlations between a continuous variable and dichotomous variable or between two dichotomous variables biases against us ﬁnding signiﬁcance because these correlations are, by statistical deﬁnition, too low (Tabachnick & Fidell, 2001, p. 58). 21. Several recent market studies have explored the effects of non-audit service fees on auditor objectivity and independence in fact (e.g., Reynolds et al., 2004;

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Frankel et al., 2002; Ashbaugh et al., 2003). While their ﬁndings are mixed, the measurement of audit fees and non-audit fees, both in magnitude and in relation to each other, signiﬁcantly inﬂuences the results.

ACKNOWLEDGMENTS We thank Steve Kaplan, Tim Louwers, Steve Moehrle, Mohammad Abdolmohammadi, Julia Higgs, Bernie Wong-On-Wing, Mary Beth Armstrong, anonymous reviewers at the 2006 Mid-Year Auditing Meeting, 2006 Western Region AAA (Outstanding Research Award), 2006 AAA Annual Meeting, and workshop participants at Washington State University, Oregon State University, University of Portland, Gonzaga University, Willamette University, and Seattle Paciﬁc University for their helpful comments.

REFERENCES American Accounting Association Financial Accounting Standards Committee (AAA FASC). (2001). SEC auditor independence requirements. Accounting Horizons, 15(4), 373–386. American Institute of Certiﬁed Public Accountants (AICPA). (1988). AICPA code of professional conduct. New York: AICPA. American Institute of Certiﬁed Public Accountants (AICPA). (1997). Serving the public interest: A conceptual framework for auditor independence New York: AICPA. Anderson, J., Jennings, M., & Reckers, P. (1993). The presence of hindsight bias in peer and judicial evaluation in public accounting litigation. Tort and Insurance Law Journal, 28(3), 462–479. Antle, R. (1984). Auditor independence. Journal of Accounting Research, 22, 1–20. Arens, A., Elder, R., & Beasley, M. (2006). Auditing and assurance services: An integrated approach (11th ed.). New Jersey: Pearson–Prentice-Hall. Ashbaugh, H., LaFond, R., & Mayhew, B. (2003). Do non-audit services compromise auditor independence? Further evidence. The Accounting Review, 78, 611–639. Bazerman, M., Morgan, K., & Loewenstein, G. (1997). The impossibility of auditor independence. Sloan Management Review, 38(4), 89–98. Beaver, W., & Demski, J. (1974). The nature of ﬁnancial accounting objectives: A summary and synthesis. Journal of Accounting Research, 12(3), 170–187. Briloff, A. J. (1966). Old myths and new realities in accountancy. The Accounting Review, 41(3), 484–495. Cronbach, L. J. (1951). Coefﬁcient alpha and the internal structure of tests. Psychometrika, 16, 297–334. Elliott, R. (1992). Audit independence: Concept and application. The CPA Journal, 62(3), 34–39. Financial Accounting Standards Board (FASB). (1990). Statements of financial accounting concepts: Accounting standards. Homewood, IL: Irwin.

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Firth, M. (1980). Perceptions of auditor independence and ofﬁcial ethical guidelines. The Accounting Review, 55(July), 451–466. Firth, M. (1981). Auditor-client relationships and their impact on bankers’ perceived lending decisions. Accounting and Business Research, 11(43), 179–188. Frankel, R., Johnson, M., & Nelson, K. (2002). The relation between auditors’ fees for nonaudit services and earnings management. The Accounting Review, 77, 71–105. Gaa, J. C. (1986). User primacy in corporate ﬁnancial reporting: A social contract approach. The Accounting Review, 61(3), 435–454. Gaa, J. C. (1992). The auditor’s role: The philosophy and psychology of independence and objectivity. In: R. Shrivasta (Ed.), Proceedings of the 1992 Deloitte and Touche/ University of Kansas symposium on auditing problems (pp. 7–43). Lawrence, KS: School of Business, University of Kansas. Geiger, M., Lowe, D. J., & Pany, K. (2002). Outsourced internal audit services and the perceptions of auditor independence. The CPA Journal, 72(April), 20–24. Hartley, R. V., & Ross, T. L. (1972). MAS and audit independence: An image problem. The Journal of Accountancy, 134(5), 42–51. Hodge, F. (2003). Investors’ perceptions of earnings quality, auditor independence, and the usefulness of audited ﬁnancial information. Accounting Horizons, 17(Suppl.), 37–48. Hussey, R., & Lan, G. (2001). An examination of auditor independence issues from the perspective of U.K. ﬁnance directors. Journal of Business Ethics, 32, 169–178. King, R. R. (2002). An experimental investigation of self-serving bias in an auditing trust game: The role of group afﬁliation. The Accounting Review, 77, 265–284. Kinney, W. (1999). Auditor independence: A burdensome constraint or core value? Accounting Horizons, 13, 69–75. Lavin, D. (1976). Perceptions of the independence of the auditor. The Accounting Review, 51(1), 41–50. Lowe, D. J. (1992). An empirical examination of the hindsight bias phenomenon in evaluation of auditor decisions. Unpublished doctoral dissertation. Arizona State University, AZ, USA. Lowe, D. J. (1994). The expectations gap in the legal system: Perception differences between auditors and judges. Journal of Applied Business Research, 10(3), 39–44. Lowe, D. J., Geiger, M. A., & Pany, K. (1999). The effects of internal audit outsourcing on perceived external auditor independence. Auditing: A Journal of Practice and Theory, 18(Suppl.), 7–26. Melancon, B. (2000). The proposed SEC rule on auditor independence and its consequences. Journal of Accountancy, 190(October), 26–28. Messier, W., Jr., Glover, S., & Prawitt, D. (2006). Auditing & assurance services: A systematic approach (4th ed.). New York: McGraw-Hill Irwin. Moore, D. (2006). SarbOx doesn’t go far enough. Business Week On Line (April 17). http:// www.businessweek.com/magazine/content/06_16/b3980122.htm Moore, D., Tetlock, P. E., Tanlu, L., & Bazerman, M. H. (2006). Conﬂicts of interest and the case of auditor independence: Moral seduction and strategic issue cycling. The Academy of Management Review, 31(1), 1–20. Nunnally, J. (1978). Psychometric theory. New York: McGraw-Hill. Pany, K., & Reckers, P. M. J. (1980). The effects of gifts, discounts, and client size on perceived auditor independence. The Accounting Review, 55(January), 50–61. Pany, K., & Reckers, P. M. J. (1983). Auditor independence and nonaudit services: Director views and their policy implications. Journal of Accounting and Public Policy, 2, 43–62.

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Pany, K., & Reckers, P. M. J. (1984). Non-audit services and auditor independence – a continuing problem. Auditing: A Journal of Practice and Theory, 3(Spring), 89–97. Pany, K., & Reckers, P. M. J. (1988). Auditor performance of MAS: A study of its effects on decisions and perceptions. Accounting Horizons, 2(June), 31–38. Previts, G. J. (1987). The scope of CPA services: A study of the development of the concept of independence and the profession’s role in society. New York: Ronald Press, Wiley. Public Company Accounting Oversight Board. (2004). Proposed ethics and independence rules concerning independence, tax services, and contingent fees. PCAOB Release No. 2004-015. Public Company Accounting Oversight Board. (2005). Ethics and independence rules concerning independence, tax services, and contingent fees. PCAOB Release No. 2005-014. Public Company Accounting Oversight Board. (2006). Ethics and independence rules concerning independence, tax services, and contingent fees. PCAOB Release No. 2006–01. Public Oversight Board (POB). (1979). Scope of services by CPA firms. AICPA. Reynolds, J. K., Deis,, D., Jr., & Francis, J. (2004). Professional service fees and auditor objectivity. Auditing: A Journal of Practice and Theory, 23(1), 29–52. Sarbanes–Oxley Act. (2002). Public company accounting reform and investor protection act of 2002. Pub. L. No. 107–204, 116, Stat. 745. Schulte,, A. A., Jr. (1965). Compatibility of management consulting and auditing. The Accounting Review, 40(3), 587–593. Schulte,, A. A., Jr. (1966). Management services: A challenge to audit independence? The Accounting Review, 41(4), 721–728. Securities and Exchange Commission (SEC). (2000a). Proposed rule S7-13-00: Revision of the Commission’s auditor independence requirements (July), SEC, New York. Securities and Exchange Commission (SEC). (2000b). Hearing testimony: Auditor independence (July 26), Washington, DC: SEC. Securities and Exchange Commission (SEC). (2000c). Hearing testimony: Auditor independence (September 13). New York: SEC. Securities and Exchange Commission (SEC). (2000d). Hearing testimony: Auditor independence (September 20). New York: SEC. Securities and Exchange Commission (SEC). (2000e). Hearing testimony: Auditor independence (September 21). New York: SEC. Securities and Exchange Commission (SEC). (2000f). Final rule S7-13-00: Revision of the Commission’s auditor independence requirements. New York: SEC. Shockley, R. (1981). Perceptions of auditors’ independence: An empirical analysis. The Accounting Review, 56(October), 785–800. Tabachnick, B. G., & Fidell, L. S. (2001). Using multivariate statistics (4th ed.). Needham Heights, MA: Allyn & Bacon. Thornton, J. M. (2003). User primacy, positive accounting theory, and nonaudit services: Evidence from the SEC’s independence hearings. Accounting and the Public Interest, 3, 36–57. Titard, P. L. (1971). Independence and MAS-opinions of ﬁnancial statement users. The Journal of Accountancy, 132(1), 47–52.

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APPENDIX Auditor Independence Survey PART 1: About the Participant (demographics) 1) Which category best describes your primary profession? Public Accounting-Audit_____ Public Accounting-Tax_____ Public Accounting-Other_____ Corporate Accounting _____ Internal Auditing_____ Management_____ Executive____ Tax Manager______ General Consultant______ Tax Consultant____ Attorney______ College Professor_____ Retired________ Other (please state)____________________________________________ 2) What are your academic degrees and/or professional certifications? BBA/BS _____ MBA_____ MSA_____ MAS _____ JD ______ MD _______ Other Accounting Related Masters _____ Other Masters_____ PHD_____ Other Degrees_________________________ CPA_____ CMA _____ CIA_____ CFE_____ CFA_____ Other (Name it) ____________ 3) How many years of experience do you have in: Public Accounting_____ Non-Public Accounting_____ 4) What is your current title? ________________________________________ 5) Gender: Male_____ Female_____ 6) What percent of your professional work involves: (The sum of the percentages must equal 100%) Audits of Public Entities ______ Audits of Non-Public Entities _____ Reviews _____ Compilations_____ Plain Paper Statements_____ Tax_____ Consulting_____ Other (explain)_____ PART 2: Questions 1. Intangible asset values included in the financial accounts should be prepared by a. Staff and directors of the companies concerned. b. Intangible asset valuers working for the company’s external auditors. c. Independent third party intangible asset valuers. 2. Auditors accepting non-audit fees will likely compromise their independence? a. Yes

b. No

c. Don’t know

3. Non-audit fees representing what percentage of total audit firm fees will likely compromise the auditors’ independence? a. None

d. 51–75%

b. 1–25% c. 26–50%

e. 76–100% f. Don’t know

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4. Which of the following auditing firm services, if contracted with the auditor’s firm by the client, would tend to compromise the auditor’s independence and judgment? a. Tax Compliance

h. Legal Services

b. Tax Planning c. Asset Valuation d. Corporate Finance

i. Actuarial Services j. Management Training k. Management Consulting

e. Treasury Management f. IT Outsourcing

l. Recruitment and Selection m. Personnel Management

g. Accountancy Outsourcing 5a. Many larger CPA firms have spun off or sold their consulting services. Would partners holding any shares in such de-merged business tend to compromise their audit firms’ independence? a. Yes

b. No

c. Don’t Know

5b. Would staff members holding any shares in such de -merged business tend to compromise their audit firms’ independence? a. Yes b. No c. Don’t Know PART 3: Scaled-Response Questions Please circle the number that indicates your level of agreement/ disagreement, where 7 is “strongly agree SA,” 1 is “strongly disagree SD” and 4 is “neither agree nor disagree.” SD

N

SA

Please circle one 1. Large accounting firms’ consulting engagements increase clients' financial power over their independent auditors?

1

2

3

4

5

6

7

a. In appearance

1

2

3

4

5

6

7

b. In fact

1

2

3

4

5

6

7

a. Better understand their client b. Perform better audits

1 1

2 2

3 3

4 4

5 5

6 6

7 7

c. Make “better” recommendations that improve their clients’ operational effectiveness. d. Lower their clients’ audit fees.

1

2

3

4

5

6

7

1

2

3

4

5

6

7

4. CPA firms should “spin off” their management consulting practices in order to strengthen their perceived independence.

1

2

3

4

5

6

7

5. CPA firms should abandon the "appearance” test for demonstrating their independence.

1

2

3

4

5

6

7

6. The CPA profession should “relax” its standard of both being independent in appearance and in fact

1

2

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7. An auditor's credibility arises more from the economic liability assumed than from maintaining independence from the client.

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2. Such large accounting firms have been “completely independent”:

3. Management consulting services help auditors:

AN INSTRUCTIONAL CASE: GORDON TECHNOLOGIES INC. Steven M. Mintz and Roselyn Morris ABSTRACT This instructional case examines revenue recognition issues over a period of time and how it affects the amount of earnings. The case is designed for a financial course either at the undergraduate or graduate level. In addition to comparative analysis, students are asked to analyze ethical issues related to how earnings were managed and the responsibilities of key employees in the financial reporting process.

INTRODUCTION Sally Horn is a Certiﬁed Management Accountant (CMA) and member of the Institute of Management Accountants (IMA). Horn works as the controller for Gordon Technologies, Inc., a large northeastern software manufacturing and development company. She joined the company in 2006 following a successful ﬁve-year career in the accounting department of a local, private company, Hartsville Networks. Horn reports to Paul Larsen, the chief ﬁnancial ofﬁcer (CFO) of Gordon Technologies. Larsen does not hold a CMA. Larsen reports to Fred Morris, the chief executive ofﬁcer (CEO) of the company, who took over in 2006 and was given a mandate by the board of

Research on Professional Responsibility and Ethics in Accounting, Volume 12, 203–217 Copyright r 2008 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1574-0765/doi:10.1016/S1574-0765(07)00209-9

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directors to increase net income and the share price of Gordon Technologies’ common stock. The company is public-owned and has an audit committee responsible for the oversight of ﬁnancial reporting.

ACCOUNTING NUMBERS While Gordon Technologies expanded its business in the ﬁrst few years after going public in 2002, the company encountered stiff competition from overseas manufacturers and net income as a percentage of revenues declined through 2005. A turnabout occurred in 2006 but the declining trend seemed to be continuing based on the projected numbers for 2007. The revenue and earnings streams during the period 2002–2007 are as follows:

Year

Revenues ($ in millions)

Net Income ($ in millions)

2002 2003 2004 2005 2006

74.00 87.90 101.10 114.90 133.75

5.95 6.60 7.00 7.45 9.55

Horn prepared the following estimates for 2007: 2007 (projected @12/31)

143.75

9.05

THE DILEMMA On January 8, 2008, Paul Larsen asked for a meeting with Sally Horn to discuss the projections she made for the ﬁscal year ended December 31, 2007. Larsen pointed out that the numbers are signiﬁcantly below ﬁnancial analysts’ estimates that were based on the turnaround in 2006. Larsen emphasized that Fred Morris is very concerned about the effect the declining numbers that might have on the company. Larsen pointed out the potential for a reduction in the company’s stock price, reductions in stock option values, and reduced bonuses for top management unless the numbers improve. He noted that if the net income trend developed in 2006 continued through 2007, then net income would be signiﬁcantly greater and the

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percentage increase in net income on a year-to-year basis would be much higher as would be net income as a percentage of revenues. Horn felt the ‘‘weight of the world’’ was being placed on her shoulders. She had never been in this kind of situation before. Horn was not sure what Larsen wanted her to do but it was clear that the numbers needed to be adjusted upward. Horn was well aware of her professional and ethical responsibilities as a CMA. However, she was also aware of her loyalty obligation to Gordon Technologies. She owed her job to Paul Larsen who is a family friend and feels an obligation to Fred Morris for being given the opportunity to be a controller of a public company. When she questioned Larsen just how the numbers were supposed to be changed, he answered by saying, ‘‘All I know, Sally, is that Fred insists the company must ‘make the numbers’ this year.’’

THE TRANSACTION After an extensive search of recent transactions, Horn identiﬁed one on December 28, 2007, whereby Gordon Technologies offered to sell its Internet infrastructure software to a customer, Grayson Inc., for Grayson’s internal use. In return, Grayson agreed to ship to Gordon Technologies similar software 15 days after December 31, 2007. Horn had omitted the amount of revenue and net income from this ‘‘swap’’ transaction for the 2007 results of operations. If the company included the revenue and proﬁts, then the former would increase by $17 million and the latter by $3.65 million. These amounts were sufﬁcient to enable the company to show a continuing upward trend in key numbers. The percentage of net income to revenues would increase enough to meet ﬁnancial analysts’ expectations; top management would receive additional bonus money; and stock prices should increase as would the value of the stock options. Horn brought the transaction to the attention of Paul Larsen. Larsen pointed out it was a win-win situation because the stockholders and top management would beneﬁt from including the transaction in the results for 2007. Larsen commented, ‘‘Who would be harmed by including the revenue in 2007 rather than 2008?’’ After discussing the matter with Larsen, Horn identiﬁed a way out of the dilemma because the title passed to the customer on December 31, 2007, when the software product was shipped free on board (FOB) shipping point. Horn reﬂected on the reasons for omitting the revenue as compared with including it because of the FOB terms and she was convinced she had done the right

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thing by omitting the transaction from the results of 2007. She pointed out to Larsen that since Grayson ordered essentially the same software from Gordon Technologies to be shipped and delivered early in 2008, the transaction should be treated as a swap transaction until that time and the revenue from the transaction should be deferred. Larsen shook his head side to side and said to Horn, ‘‘You need to carefully consider your decision in this situation.’’ Horn went back to her ofﬁce to contemplate her dilemma.

ACCOUNTING CONSIDERATIONS Horn knows that the swap transaction is linked to Gordon Technologies’ agreement to take the Grayson product on January 15, 2008. While she does not anticipate any problems in that regard, she is uncomfortable with the recording of revenue on December 31, 2007 since Grayson did not complete its portion of the agreement by that date. Horn is also concerned about the fact that another transaction occurred during the previous year that she had questioned but, in the end, went along with Larsen’s accounting for the transaction. Horn was approached by Larsen in this instance and was told that it was a one-time request because the new CEO wanted to put a good face on the ﬁnancial statements in his ﬁrst year at the helm of Gordon Technologies. Last year’s transaction took place on December 30, 2006, when Gordon Technologies sold a major system for $16 million ($2 million net income) to Kelsey Communications but executed a side agreement with Kelsey on December 31, 2006 that gave Kelsey an unconditional right to return the product for any reason after January 1, 2007 and for 30 additional days. Even though Horn recorded the revenue on December 31, 2006 and felt uneasy about it, she did not object because Kelsey did not return the product. Horn never brought it up again. Now she is concerned that a pattern may be developing.

DISCUSSION QUESTIONS 1. Comment on the corporate culture at Gordon Technologies? If you were in Sally Horn’s position, would it raise any ‘‘red ﬂags?’’ Be speciﬁc in identifying these potentially troublesome situations. Evaluate Horn’s decision not to challenge the December 28, 2006 transaction from an ethical perspective? Do you think the decision was ‘‘right’’ or ‘‘wrong?’’

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2. What are Sally Horn’s ethical and professional responsibilities under the IMA Standards of Professional Practice? In particular, analyze the following: (a) Whether she has adhered to the principles. (b) What are Horn’s ethical and professional obligations given the difference of opinion with Paul Larsen, the CFO of the company? 3. Describe the rules in accounting for revenue recognition in general and relate them to the two transactions mentioned in the case. Do you believe the transactions have been accounted for properly? What are the effects on revenues and net income of allowing Gordon to go ahead with its accounting? 4. (a) Prepare a schedule of the percentage of net income to revenues from 2002 through the projected amounts for 2007. Use the original amounts reported including that for 2006 and also show the percentage change in revenue and net income each year. (b) Recalculate the 2007 amounts from part (a) including the effects of the Grayson transaction on revenues, net incomes, and relevant percentage calculations. (c) Recalculate the 2006 and 2007 amounts from part (a) assuming the company restates the results for 2006 to reﬂect the proper treatment of the December 30, 2006 transaction. 5. Examine the results in Question 4 and describe what you think Gordon Technologies was trying to accomplish in its handling of the two revenue transactions and what was the motivation for its actions. 6. Assume Sally Horn is to meet with Paul Larsen on January 15, 2008, to ﬁnalize the accounting for the Grayson revenue and net income. Horn asks Corrine Johnson, her best friend, for advice. Johnson holds the CMA and has been the CFO of a large international ﬁrm for many years. Therefore, you can assume Johnson is knowledgeable about IMA’s standards and the expected corporate culture in a public company. Prepare a draft of the recommendations Johnson might make to Horn that outlines the ethical issues, alternatives, and a recommended course of action. 7. Regardless of your answer to Question 6, assume Horn asks for more time to consider the matter when she meets with Larsen on January 15, 2008. She points out that the auditors will not arrive until February 1, 2008; therefore, the company should be certain of the appropriateness of its accounting before that time. Larsen reacts angrily and tells Horn to pack her bags and go if she does not support the company in its revenue recognition of the Grayson transaction. Assume you are in Horn’s position. What ethical considerations might help you to decide on a course of action under these circumstances? What would you do and why?

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TEACHING NOTES Placement of Case in the Curriculum The case is most useful in a separate accounting ethics course at the university level. It can be used in an upper-division ﬁnancial and managerial accounting course and in auditing. The case also can be used to meet a state board of accountancy’s continuing education requirement in ethics. The case has widespread appeal because it deals more with issues and concepts about ethics and less about technical accounting topics. In fact, the only technical topic is revenue recognition and most students learn enough about it in the basic ﬁnancial and intermediate accounting courses. The case also can be used in a graduate-level course in ﬁnancial and managerial accounting and reporting, controllership, and auditing. If the case was used at the graduate level, coverage of revenue recognition issues, earnings management, and the Sarbanes–Oxley Act (SOX) could be added to expand the horizons of the case. Pedagogy The case has been used by one of the authors by dividing students into groups, having them discuss the case, and then handing in written responses to the questions. One group was chosen to role-play their answer to Question 7 with the instructor. An informal survey indicated the students were very supportive of this approach. There were other cases in the class, so each group had an opportunity to engage in role-playing before the end of the term. The class size was 15 and ﬁve groups of three were chosen because there were ﬁve cases during class time covered in this manner.

SUGGESTED SOLUTIONS TO DISCUSSION QUESTIONS 1. The corporate culture at Gordon Technologies seems to be one of not following ethical or professional principles. It reﬂects putting pressure on key employees to go along with what management is trying to achieve in its application of accounting standards. Given that Paul Larsen, the CFO, is pressuring Sally Horn to record the swap revenue in 2007 as he had done with the right of return revenue in 2006, we can conclude that the pressure

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begins at the top of the company with Fred Morris, the CEO. It is highly unlikely that Larsen would act this way on two occasions without Morris’ consent. Therefore, the company’s culture lacks an ethical tone at the top that supports acting in accordance with professional and ethical standards. One ‘‘red ﬂag’’ that should alarm Horn is the premature recording of revenue two years in a row. The shifting of revenue is important in terms of revenues and net income for both years. In 2006, revenue increased by 16.41% and there was a 28.19% increase in income. In 2007, the potential increase in revenue if the swap transaction is recorded that year is 20.19% and 32.98% for net income. Horn’s decision in 2006 to go along with the company’s position and prematurely record the revenue on the swap transaction may have been a rationalization that it was a one-time transaction at year end and would not happen again. However, Paul Larsen seemed to feel comfortable approaching Horn a second time in 2007 after she had gone along with the right of return treatment in 2006. Horn’s decision in 2006 led her down the ‘‘ethical slippery slope’’ and it probably made it much more difﬁcult to resist company pressure on the swap transaction in 2007. The rationalization of the accounting for the right of return and then swap transactions is wrong from an ethical perspective because it favors the self-interests of top management and ignores the interests of stockholders and creditors who rely on accurate ﬁnancial statements for their decision making. The public interest must be placed ahead of the self-interests of the company and top management. Horn should know that an action should not be undertaken if it places loyalty to management above loyalty to public interest. One way of viewing the public interest dimension of accounting is to look at the IMA’s Statement of Ethical Professional Practice1 that deﬁnes principles of professional conduct and standards of conduct that follow from those principles. In particular, the credibility standard requires that the holder of a CMA that belongs to the IMA ‘‘disclose all relevant information that could reasonably be expected to inﬂuence an intended user’s [e.g., stockholder and creditor] understanding of the reports, analyses, or recommendations.’’ The accounting treatment of the right of return and swap transactions fail to live up to the principle of honesty since revenue and net income are not presented in accordance with generally accepted accounting principles (GAAP). The true effect of those amounts are manipulated to meet management’s perceived needs and the ﬁnancial statements do not provide full and accurate information to the users of those reports.

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2. Horn is obligated to adhere to the overarching principles of the Statement of Ethical Professional Practice and its underlying standards of conduct in the performance of professional services. The principles include honesty, fairness, objectivity, and responsibility. The underlying standards include competence, conﬁdentiality, integrity, and credibility.2 (a) Horn has not adhered to the principles and standards in the following ways: (1) Her conduct fails the competence test because she has not followed technical accounting standards. GAAP standards can be used as a measure of competence since they are required of Certiﬁed Public Accountants (CPAs) and have broad acceptance in the accounting profession. (2) She violated the integrity standard when she ‘‘engaged in y conduct that would prejudice carrying out duties ethically.’’ In 2006 Horn went along with improper accounting for the right of return transaction agreeing to record revenue prematurely even though she knew it was the wrong decision. She allowed herself to be convinced by Paul Larsen that this was a one-time request to make the numbers look better for the CEO’s performance evaluation. (3) She violated the credibility standard because all information was not communicated fairly and objectively. Moreover, she did not disclose all relevant information that could reasonably be expected to inﬂuence an intended user’s understanding of the reports, analyses, or recommendations. Horn allowed herself to be biased toward the company’s position and away from GAAP in the recording of the right of return revenue. Nothing in the case suggests that there was a disclosure about the right of return transaction or that disclosure will occur for the swap transaction. (b) The IMA standards provide a clear set of steps that should be taken when a member identiﬁes unethical behavior. First, Sally Horn should look at the company’s policies for guidance in resolving the difference of opinion with Paul Larsen. For example, there may be a code of ethics to resolve such differences. Second, if the policies do not resolve the conﬂict, then the standards require the following speciﬁc steps to resolve the conﬂict: (1) Horn should discuss the issue with Larsen, her immediate supervisor. However, since it is clear that Larsen is involved in the dispute, Horn should present it to the next level. In this case it means to discuss the situation with Fred Morris, the CEO, and if it is determined the CEO directed Larsen to adopt the improper

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211

positions on revenue recognition matters then the next step would be to discuss the conﬂict with the board of directors or the owners of the entity or another oversight group such as the audit committee. Contact with levels above the immediate superior should be initiated only with the supervisor’s knowledge, assuming that the party is not involved. Communication outside the company is not considered appropriate unless there is a clear violation of the law. (2) Horn should clarify the relevant ethical issues by initiating a conﬁdential discussion with an IMA ethics counselor or other impartial advisor to better understand alternative courses of action. (3) Horn should consult her attorney for legal obligations and rights concerning the ethical conﬂict. It is worth noting that had Horn been a CPA, the steps would be the same under the Integrity and Objectivity Rule 102–4 that explains the process to avoid subordinating judgment to a superior. Fig. 1 depicts the process Horn should follow to resolve the ethical conﬂict that would have existed for Larsen with respect to the right of return transaction in 2006 and the swap transaction at the end of 2007. 3. Revenue from the sale of goods should be recognized when it is both earned and realized or realizable. In other words, the earning process must be complete or virtually complete and the revenue measurable. Important considerations in product sales are whether title and the signiﬁcant risks and rewards of ownership have passed to the customer. FOB terms, sale terms, and the entity’s business practices should be considered in these determinations. FOB terms are an important consideration in product sales because they determine the point at which title to the product, and thus the risks and rewards of ownership, have legally passed to the buyer. FOB destination indicates that title to the product passes upon delivery to the customer. FOB shipping point indicates that title to the product passes at the time of shipment. The revenue from the sale to Grayson is not earned or realizable due to the agreement for Gordon to take Grayson’s product 15 days from December 31, 2007. The economic substance of the transaction indicates risks and rewards passed to Grayson on January 15, 2008. Legal ownership (title) does not pass on December 31, 2007 when the goods are shipped to Grayson. The sale will be complete, realized, and earned when Gordon Technologies receives and accepts Grayson’s product.

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Accounting Conflict

Immediate supervisor not involved

End process

Yes

Immediate supervisor is involved

Accounting conflict resolved No

Seek advice immediately

Take matter to next level of management, e.g. CEO, Board of Directors End process

Yes

Accounting conflict resolved

No

Clarify relevant ethical issues with IMA Counselor

Consult legal counsel as to legal obligations and rights

Fig. 1. IMA Process: Resolution of Ethical Conﬂict. Note: Dotted lines show the importance of getting advice once it is determined the immediate supervisor is involved.

If Gordon was allowed to keep its current revenue treatment including that desired for 2007, then revenue would be overstated for 2006 as would net income and both would be understated in 2007. The swap transaction overstates revenue and net income in 2007 and understates both in 2008. One danger of allowing Gordon to keep its current accounting is that the company could capitalize the cost of the assets received in return for the products shipped by Grayson in 2007 and Kelsey Communication in 2006.

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These acquisitions could then be inappropriately written off over a number of years creating a matching problem with the aforementioned revenue. 4. Response to Question 4

Year

Revenues Net Income NI:Rev (%) Change in (Rev) (NI) Rev (%)

Change in NI (%)

Response to Question (a) 2002 74.00 2003 87.90 2004 101.10 2005 114.90 2006 133.75 2007 (projected 143.75 @ 12/31)

5.95 6.60 7.00 7.45 9.55 9.05

8.04 7.51 6.92 6.48 7.14 6.30

18.78 15.02 13.65 16.41 7.48

10.92 6.06 6.43 28.19 (5.24)

Response to Question (b) 2007 (projected 160.75 @ 12/31)

12.70

7.90

20.19

32.98

Response to Question (c) 2006 117.75 2007 (projected 159.75 @ 12/31)

7.55 11.05

6.41 6.92

2.48 35.67

1.34 46.36

5. Gordon appears to be trying to boost revenues and net income by an amount sufﬁcient to show growth in 2007 equal to or exceeding the amounts in 2006. The comparative changes in revenues and net income are as follows:

Year

2006 2007 (projected @ 12/31) (without swap) 2007 (projected @ 12/31) (with swap)

Revenues Net Income NI:Rev (%) Change in (Rev) (NI) Rev (%)

Change in NI(%)

133.75 143.75

9.55 9.05

7.14 6.30

16.41 7.48

28.19 (5.24)

160.75

12.70

7.90

20.19

32.98

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STEVEN M. MINTZ AND ROSELYN MORRIS

If Gordon Technologies excludes the swap transaction from the results for 2007, its revenues increase at a slower pace and net income declines in comparison to 2006. In particular, the net income in 2007 is $9.05 million without the swap transaction and $12.70 million with the swap. The difference is quite dramatic because it reﬂects a reduction in the percentage change in net income from (5.24%) without the swap in comparison to 32.98% with the swap transaction. Moreover, the continuing trend of increases in net income amounts would be broken in 2007. The likely result would be a drop in the stock price, reduced or eliminated bonuses for top management, and a lessening in stock option values. It appears the company is trying to manage earnings by identifying transactions that can be used to shift revenues and net income into one year and out of another. The swap transaction allows the company to shift income into 2007 and out of 2008. The right of return transaction shifts income out of 2007 and into 2006. By managing earnings, the company winds up following its own rules as to what are GAAP and not the standards that exist in the accounting profession. These actions impair the credibility of the company and Horn’s association with earnings management raises questions about her ability to meet the IMA’s Statement of Ethical Professional Practice. Those who hold a CMA are expected to be competent and Sally Horn would violate that standard if she goes along with Paul Larsen’s proposed accounting for the swap transaction. One aspect of that standard is to perform professional duties in accordance with relevant laws, regulations, and technical standards. Using GAAP as the standard, it is clear that Gordon Technologies will fail to follow technical standards if the company includes the swap transaction in 2007 instead of 2008, and when it convinced Horn to include the right of return transaction in 2006 rather than in 2007. Moreover, the reporting actions could put top management in jail since they are ‘‘illegal’’ and the Securities and Exchange Commission (SEC) could take action. Horn would also violate the objectivity of overarching principle if she allows Paul Larsen to make the ﬁnal determination of how to record the swap transaction. To do so would lead to a subordination of professional judgment and a loss of integrity. Moreover, she has an ethical obligation to restate the results for 2006 and 2007 because of the premature recognition of revenue in 2006. 6. Corine Johnson should emphasize Sally Horn’s ethical and professional responsibilities under the Statement of Ethical Professional Practice of the

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IMA. In particular, Johnson should point out Horn’s obligation to have integrity, objectivity, and to act in an honest and credible manner. Of particular importance is for Johnson to remind Horn that under the IMA’s ethical standards, she can contact an ethics counselor for advice on the matter and should consider contacting her attorney to clarify her legal obligations.3 An audit committee exists for Gordon Technologies as would be expected since the SOX of 2002 requires it for all public-owned companies.4 Therefore, Johnson should remind Horn of the important step that is depicted in Fig. 1 of taking a conﬂict to the CEO and board of directors, or the audit committee in the case of a public company. The role of the audit committee is to oversee ﬁnancial reporting matters and intervene when differences exist between what should be the proper accounting and what top management wants the numbers to show. Of particular importance is for Johnson to remind Horn of the responsibilities of top management under SOX. Section 302 requires that the principle executive ofﬁcer or ofﬁcers and the principle ﬁnancial ofﬁcer or ofﬁcers must certify each annual and quarterly report ﬁled with the SEC. The certiﬁcations should help to convince top management not to sign off on something that is not truthful. They probably have already done so in 2006 and should not compound the problem in 2007. The 2006 ﬁnancial statements can be restated to correct for the improper accounting. The certiﬁcations emphasize the following three important points indicated below:5 (1) Based on their knowledge (e.g., CEO and CFO), 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 not misleading. (2) Based on an ofﬁcer’s information, the ﬁnancial statements and other ﬁnancial information included in the report are fairly presented in all material respects of the ﬁnancial condition and results of operations of the company for the periods presented in the report. (3) The signing ofﬁcers are responsible for establishing and maintaining internal controls and evaluating the effectiveness of such controls within 30 days prior to the report. The ofﬁcers must also present in the report their conclusions about the effectiveness of internal controls based on the evaluation of that date. Section 404 of SOX also requires that management should state their responsibility for establishing and maintaining an adequate internal control structure and procedures for ﬁnancial reporting. The report should contain

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an assessment, as of the end of the most recent ﬁscal year of the company, of the effectiveness of the internal control structure and procedures of the company for ﬁnancial reporting.6 The alternative courses of action open to Horn include (1) Doing nothing, which means Horn allows the right of return transaction of 2006 to stand and she remains a party to the false accounting. It might also mean she refuses to shift the swap revenue from 2008 into 2007, which is the ethical position to take regardless of the personal consequences to Horn. (2) Agreeing to record the swap revenue in 2007. This is the most unethical position to take because Horn goes along with improper accounting on two occasions. (3) Refusing to go along with the recording of the swap revenue and insist on a correction for the right of return transaction. This is the most ethical position for Horn to take and the one that adheres to the principles and standards in IMA’s Statement of Ethical Professional Practice. Horn maintains her integrity, enhances her credibility, and honors her obligations to the public trust. Johnson should recommend Horn to adopt the third alternative and also remind her to consult her attorney to discuss legal obligations and rights concerning the ethical conﬂict. Johnson may recommend that Horn should ‘‘dust off’’ her resume and start exploring other employment opportunities. In the end, Johnson should remind Horn that the most important asset for accountants is their reputation for integrity. By going along with improper accounting of an employer or client, the accountant sacriﬁces integrity for the sake of one’s self-interest. 7. The fact that Paul Larsen refuses to allow Horn more time to study the issues at hand is a red ﬂag for Horn that Larsen does not want to discuss the matter any further. The company’s position is non-supportive because a few days more should not matter to ‘‘get it right.’’ On the other hand, Horn already has had more than two weeks to study the issues and professional competence dictates her to come up with an opinion by the agreed date of January 15, 2008. Horn knows the company does not honor her perspective since a decision was made before the January 15, 2008 meeting based on Larsen’s statement to ‘‘pack her bags and go.’’ Horn knows that the external auditors rely on the work of internal accountants and auditors. How can Horn, in good conscience, go along with the misleading numbers? She would lose the trust of the external auditors

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and violate her professional responsibilities to the users of the ﬁnancial reports. She would be allowing the CFO to make the ﬁnal decision on proper accounting when it is the controller’s job to make that decision. This is especially true in the Gordon Technologies case since Horn holds the CMA but Paul Larsen does not. Horn is at risk because Gordon Technologies is a publicly owned company and comes under the purview of the SEC. By now it should be clear to Horn that she is heading down the ethical slippery slope and she had better stop the slide before it is too late. She can refuse to go along with the inclusion of the swap revenue for 2007 and insists that the books should be corrected for 2006. If the company fails to support her with respect to these transactions, then it is best for Sally to move on. She does not want to get locked into a position where her opinion is not honored and constantly has to cover up improper accounting. This is exactly what a company such as Gordon Technologies expects of an accountant once that person ﬁrst goes along with improper accounting. In a sense it is as if the company can say to their accountant at a later point in time, ‘‘Gotcha.’’

NOTES 1. Institute of Management Accountants, Statement of Ethical Professional Practice, http://www.imanet.org/about_ethics_statement 2. Ibid. 3. Ibid. 4. HR 3763 The Sarbanes–Oxley Act of 2002, July 2002, http://www.ﬁndlaw/ hdocs/docs/gwbush/sarbanesoxley072302.pdf 5. Ibid., pp. 33–34. 6. Ibid., p. 45.

ACKNOWLEDGMENTS This case can be found in Ethical Obligations and Decision Making in Accounting by Steven Mintz and Roselyn Morris, r 2008, McGraw-Hill/ Irwin.

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