Accounting and ethics
A number of user groups rely on the financial statements to make economic decisions. It is important that these users are not misled.
However, the ethical beliefs of individual accountants may be too simplistic when dealing with real-life, complex ethical dilemmas. The study of ethics is therefore vital so that accountants develop the skills that will help them to decide on the right course of action.
2 Approaches to accounting and ethics
Rules and principles
Some national accounting standards are primarily rules based. In other words, they provide extensive and detailed guidance about the accounting treatment of particular transactions.
This approach is sometimes criticised for nurturing a ‘rule-book mentality’. In fact, complying with the letter of the law rather than the spirit of the accounting standard may prevent transactions from being faithfully represented.
International Financial Reporting Standards are often principles based, albeit with some detailed rules in place to eliminate uncertainties and to increase comparability.
Such principles-based approaches to accounting create ethical challenges because of the professional judgement that accountants are required to exercise. An understanding of ethical principles, such as those contained in the ACCA ethical code, is therefore essential.
3 Ethical codes
The ACCA ethical code
The ACCA requires its members to adhere to a code of professional ethics. This provides a set of moral guidelines for professional accountants.
The fundamental principles of this code are:
- Integrity – to be straightforward and honest in all professional and business relationships.
- Objectivity – to not allow bias, conflict of interest or undue influence of others to override professional or business judgments.
- Professional Competence and Due Care – to maintain professional knowledge and skill at the level required to ensure that a client or employer receives competent professional services based on current developments in practice, legislation and techniques and act diligently and in accordance with applicable technical and professional standards.
- Confidentiality – to respect the confidentiality of information acquired as a result of professional and business relationships and, therefore, not disclose any such information to third parties without proper and specific authority, unless there is a legal or professional right or duty to disclose, nor use the information for the personal advantage of the professional accountant or third parties.
- Professional behaviour – to comply with relevant laws and regulations and avoid any action that discredits the profession.
Some of the elements of the ethical code are now considered in more detail.
Acting with integrity involves being honest and straight-forward. Any attempt to conceal or hide transactions, either through omitting them or through inadequate or confusing disclosure, demonstrates a lack of integrity.
Later in this text, you will learn that forms of non-financial reporting are becoming increasingly important. Many entities prepare reports that detail their relationship with, and impact on, society and the environment. These issues could be combined in an integrated report. Such reports are voluntary. However, it could be argued that withholding information from users about a company’s social and environmental impact lacks integrity. Moreover, failing to report issues about long-term sustainability may be just as misleading as incorrect information within the historical financial statements.
There are many times when an accountant might find that they have an incentive to represent the performance or position of a company in a particular way:
- Profit related bonuses: An accountant might be motivated to maximise profit in the current period in order to achieve their bonus. Alternatively, if current period targets have been met, an accountant might be motivated to shift profits into the next reporting period.
- Financing: An entity is more likely to be given a loan if it has valuable assets on which the loan can be secured. An incentive may therefore exist for the accountants to over-state assets on the statement of financial position.
- Achieving a listing: A company that is being listed on a stock exchange will want to maximise the amount that it receives from investors. Therefore, there may be an incentive for the accountants to over-state the assets and profits of a company before it lists.
Financial statements should faithfully represent the transactions that have occurred. The ethical code encourages accountants to not let bias or outside influence impact their judgements.
Areas of judgement in financial statements
One of the reasons why objectivity is such an important part of the ACCA ethical code is that accounting standards frequently involve the use of judgement. Bias would therefore have a direct impact on the financial statements produced. Some examples of the judgements required by IFRS Standards are presented below:
- Many standards permit assets or liabilities to be held at fair value. IFRS 13 Fair Value Measurement defines fair value as ‘the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date’. IFRS 13 stresses the importance of level 1 inputs – quoted prices for identical assets and liabilities in active markets – but, in the absence of these, allows more judgemental measures to be used.
- IAS 16 Property, Plant and Equipment states that entities should depreciate assets over their estimated useful life. By over-stating an asset’s useful economic life, depreciation is charged more slowly to profit or loss.
- IAS 36 Impairment of Assets says that the recoverable amount of an asset is the higher of the fair value less costs to sell and the value in use. Both of these figures involve judgements about events that will happen in the future and are therefore open to manipulation.
- IFRS 2 Share-Based Payment requires entities to estimate the expense of an equity-settled share-based payment scheme based on the number of options expected to vest. By under-estimating the number of options expected to vest, profit in the short-term might be maximised.
- IAS 37 Provisions, Contingent Liabilities and Contingent Assets states that provisions should recorded at the best estimate of the expenditure to be incurred. Using lower than expected estimates will reduce the value of a provision and therefore maximise current year profits.
Unless an accountant understands and adheres to the code of ethics, then manipulation of these (and other) standards is likely. The financial statements would therefore not faithfully represent the performance and position of the entity and the users may be misled into making incorrect economic decisions.
Professional competence and due care
As you will be aware from your studies, new accounting standards are frequently issued and older standards are often updated or withdrawn. This means that accounting knowledge becomes out-of-date very quickly.
In order to comply with the code of ethics, accountants have a responsibility to ensure that they are aware of changes to accounting standards. This is often referred to as CPD (Continuing Professional Development).
- Reading technical articles
- Attending seminars or presentations
- Attending training courses
Without up-to-date technical knowledge, it is unlikely that an accountant can produce financial statements that comply with IFRS Standards. Material errors within financial statements will mislead the users.
4 The impact of ethical and unethical behaviour
Consequences of unethical behaviour
The journals and magazines of professional institutes regularly include details of professional disciplinary proceedings brought against individual members who were believed to have fallen short of the ethical standards expected of them.
The consequences of unethical behaviour in deliberately presenting incorrect financial information are severe. Many accountants have been fined or jailed for not fulfilling their professional duties.
The consequences for individuals include:
- The loss of professional reputation
- Being prevented from acting as a director or officer of a public company in the future
- The possibility of being expelled by a professional accountancy body
- A prison sentence.
Ethics and the profit motive
It is commonly argued that the primary objective of a company is to maximise the wealth of its shareholders. Acting ethically might be seen to contradict this objective. For example, whilst it may be ethical to incur costs associated with looking after the environment, such costs reduce profits.
However, in modern society, companies are considered to be corporate citizens within society. Corporate social responsibility is increasingly important to investors and other stakeholders. It can attract ‘green’ investors, ethical consumers and employees and so in turn have a positive impact on financial results. Thus, it could be argued that the performance and sustainability of a company may not be maximised unless it behaves in an ethical manner.
Test your understanding 1 – Cookie
The directors of Cookie are very confident about the quality of the products that the company sells. Historically, the level of complaints received about product quality has been low. However, when calculating their warranty provision, they have over-estimated the number of items that will be returned as faulty. The directors believe that this is acceptable because it is important for financial statements to exhibit prudence.
Discuss the ethical issues raised by the treatment of the warranty provision.
Test your understanding answers
Test your understanding 1 – Cookie
Financial statements are important to a range of user groups, such as shareholders, banks, employees and suppliers. Prudence is important because over-stated assets or under-stated liabilities could mislead potential or current investors. However, excessive cautiousness means that the financial performance and position of an entity is not faithfully represented.
A faithful representation is often presumed to have been provided if accounting standards have been complied with. It would appear that the directors are not calculating the provision in line with the requirements of IAS 37, which requires provisions to be recognised at the ‘best estimate’ of the expenditure to be incurred. This may mean that profit is understated in the current period and then over-stated in subsequent periods.
Professional ethics is a vital part of the accountancy profession and ACCA members are bound by its Code of Ethics and Conduct. This sets out the importance of the fundamental principles of confidentiality, objectivity, professional behaviour, integrity, and professional competence and due care.
Integrity is defined as being honest and straight-forward. Over-estimating a provision in order to shift profits from one period to another demonstrates a lack of integrity.
If the provision is being over-stated in order to achieve bonus targets or profit expectations in the next financial period, then this demonstrates a lack of objectivity.
If the directors are unaware of the requirements of IAS 37, then they may not be sufficiently competent.
Financial statements should faithfully represent the transactions that have occurred. Compliance with the ethical code thus encourages accountants to ensure that they are technically capable and sufficiently independent to comply with the requirements of IFRS Standards.