MENU

Ethics, Accountancy, and Economic Activity

Send to Kindle

By Donna F. Paris

August 20, 2017

 

The audit failures disclosed by the PCAOB inspections were not that the firms failed to detect actual fraud 25% to 48% of the time, but rather 25% to 48% of the time the firms failed to obtain sufficient evidence to support their opinions that the financial statements were fairly stated. If fraud was present, the ability of these firms to detect it was impaired.

Twenty-first century economic activity is enormously complex. On a global scale, producers produce, lenders lend, investors invest, employers employ, workers work, suppliers supply, consumers consume. At the center stand accountants and auditors—accountants who record, present and report the underlying economic transactions and auditors who lend credence to the millions of assertions and decisions made hourly by millions of participants in economic activity. What happens in practice? Sometimes, corruption, fraud, failure. Some auditors violate their independence by subordinating their judgment to that of the other stakeholders in economic activity. Some tax accountants help their clients commit tax fraud. This doesn’t negate the value of auditing and accounting, but it does corrupt it.

In 2011, David Cay Johnston, (David Cay Johnston, “A History of Audit Failures,” Reuters, November 11, 2011) reminded us of several cases spanning decades in his article “A History of Audit Failures”: Ivar Kreuger’s Ponzi Scheme in 1932, McKesson & Robbins in 1938, National Student Marketing in 1970, Equity Funding in 1973, ZZZZ Best in 1987, Sunbeam in 1998, Waste Management in 2002, Adelphia in 2004, and Olympus in 2009. He didn’t mention Enron, perhaps because he thought there was no point beating that already dead horse.

Enron might be dead and gone, but as a result of its chicanery, Congress established the Public Company Accounting Oversight Board (PCAOB), created by the Sarbanes-Oxley Act of 2002 (the Act), “to oversee the audits of public companies in order to protect the interests of investors and further the public interest in the preparation of informative, accurate and independent audit reports.” (Sarbanes-Oxley Act of 2002, Title I, Sec. 101 (a), July 30, 2002). In accordance with the Act, the PCAOB assesses public company auditors’ compliance with the Act, Securities and Exchange Commission and PCAOB rules, and accountancy’s professional standards.

In 2013, Tammy Whitehouse, blogging at Compliance Week, an information service on corporate compliance and governance for U.S. public companies, noted, “PCAOB inspection reports for 2012 showed the failure rates among the Big Four accounting firms ranging from a low of 25% of all audits inspected at Deloitte to 48% at Ernst & Young.” (Tammy Whitehouse, “Audit Failure Themes Persist in 2013, Munter Says,” Compliance Week, December 11, 2013), KPMG and PricewaterhouseCoopers, not cited, presumably fell somewhere in between.

At the end of 2013, Helen Munter, PCAOB Director of Registration and Inspections, stated that the results of their 2013 inspections disclosed the same types of audit failures noted in previous years, although she conceded it was not clear at that time if the negative trend had decelerated (Public Company Accounting Oversight Board, PCAOB Release No. 2013-011, December 6, 2013).

The audit failures disclosed by the PCAOB inspections were not that the firms failed to detect actual fraud 25% to 48% of the time, but rather 25% to 48% of the time the firms failed to obtain sufficient evidence to support their opinions that the financial statements were fairly stated. If fraud was present, the ability of these firms to detect it was impaired.

These are the four largest and most prestigious accounting firms on the planet! How and why does this happen and what’s the solution?

According to Johnston (David Cay Johnston, “A History of Audit Failures,” Reuters, November 11, 2011), the fundamental reason is the structure and rules of auditing that, he claims, enable collusion between immoral businessmen and auditors.

“It … is not as if we lack for warnings that too many auditors are in on the frauds — either looking the other way or actively helping companies hide financial lies.”

His recommendation? More oversight by regulators as evidenced by his questions:

“Why do we let corporations pick their auditors? Why do we have only four big firms instead of a dozen, a score or more? Why doesn’t government do the audits, as the IRS does tax audits? Why is law enforcement handcuffed by inadequate budgets and rules that hinder investigations? Why are auditors allowed to quietly resign instead of being required to blow the whistle?”

His conclusion:

“Auditing needs a shakeup, fundamental restructuring and the accounting firms need a serious debate about their failings, practical and moral.”

The PCAOB concluded that the failures resulted from a variety of causes: failure by the firms to adequately design and/or implement their systems of quality control, to adequately train staff, and to adequately handle workload pressure. It did not conclude the failures were “moral” failures.

Johnston believes more government oversight can solve the problem, but 10 years after it was formed, the PCAOB had not effected improvements.

So, what’s the real reason? Why do auditors sometimes fail to identify, expose and report fraud? And how can these failures be eliminated? Before we can answer these questions, we need to identify the nature of accountancy and examine the premises and principles in the Code of Professional Conduct.

So, what’s the real reason? Why do auditors sometimes fail to identify, expose and report fraud? And how can these failures be eliminated? Before we can answer these questions, we need to identify the nature of accountancy and examine the premises and principles in the Code of Professional Conduct (AICPA Code of Professional Conduct, December 15, 2014, updated for all Official Releases through August 31, 2016) that governs the profession and evaluate whether the Code can achieve the goal it was designed to accomplish.

Accountancy is a complex body of specialized knowledge that exists within the context of economic activity. Accountancy’s role in economic activity is to provide accurate information about economic transactions to any and every individual to whom such information is relevant. How does the Code of Professional Conduct attempt to ensure success in fulfilling that role?

The Holy Trinity of the accounting profession is integrity, objectivity and independence – in that order. I would change the order to objectivity, independence and integrity, but that’s nit-picking.

The Code defines these as follows:

Integrity: acting in accordance with the principles
(1) No knowing misrepresentation of the facts
(2) Compliance with professional standards

Objectivity: adherence to the facts
(1) Measurement and reporting corresponds to objective facts supported by evidence

Independence: in fact and in appearance
(1) No direct or indirect financial interest in the auditee; no decision-making role on behalf of the auditee

(2) No subordination of judgment to others

According to the Code (AICPA Code of Professional Conduct, December 15, 2014, updated for all Official Releases through August 31, 2016), the fundamental principle underlying these three is the public interest. Section 0.300.030, The Public Interest states:

“.01 The public interest principle. Members should accept the obligation to act in a way that will serve the public interest, honor the public trust, and demonstrate a commitment to professionalism.”

“.02 A distinguishing mark of a profession is acceptance of its responsibility to the public. The accounting profession’s public consists of clients, credit grantors, governments, employers, investors, the business and financial community, and others who rely on the objectivity and integrity of members to maintain the orderly functioning of commerce. This reliance imposes a public interest responsibility on members. The public interest is defined as the collective well-being of the community of people and institutions that the profession serves.”

“.03 In discharging their professional responsibilities, members may encounter conflicting pressures from each of those groups. In resolving those conflicts, members should act with integrity, guided by the precept that when members fulfill their responsibility to the public, clients’ and employers’ interests are best served.”

The Code begins by assuming accountancy’s fundamental role and value lie not in recording, presenting and reporting economic activity, but in protecting the public interest. It defines this interest as the well-being of the various participants in economic activity and obligates the accountant to achieve their well-being even in the face of their possible conflicting interests and mandates. How? Well, the Code is 189 pages long and filled with rules and interpretations of those rules that address specific questions, but it doesn’t acknowledge that one participant – the accountant – cannot single-handedly solve the problems that might arise. Instead, the Code stipulates specific behaviors in addition to recording, presenting and reporting economic activity that it asserts will ensure protecting the public interest. This often results in conflicting rules. For example, the accountant is required to comply with the cardinal rule of protecting client confidentiality and at the same time is required to comply with laws and regulations that might include reporting suspected malfeasance to regulators. The Code does detail procedures the accountant should follow to attempt to resolve the conflict, but ultimately, the Code’s solution in the case of an unresolvable conflict is for the accountant to withdraw from association with the conflict (quit his or her job, or withdraw from the engagement, or terminate the client relationship) and suffer the consequences of failing to comply with one or the other requirement. Unfortunately, when faced with the alternatives of (1) protecting the client’s confidentiality, (2) complying with regulators’ mandates to the contrary, or (3) economic suicide, many accountants will resort to the philosophy of Pragmatism.

Pragmatism is the philosophical doctrine that practical consequences are the criteria of knowledge, meaning and value (Princeton’s WordNet). It rejects the idea that the purpose of thinking is to identify, describe, represent or evaluate reality. Instead, it holds that ideas must be evaluated in terms of their practical consequences. A principle is an idea that explains a fundamental aspect of reality and is used as a basis for thinking and as a rule for choosing among alternative solutions to a problem. Pragmatism divorces the choice of solutions from principles and offers no practical guidance.

Pragmatism is the philosophical doctrine that practical consequences are the criteria of knowledge, meaning and value (Princeton’s WordNet). It rejects the idea that the purpose of thinking is to identify, describe, represent or evaluate reality. Instead, it holds that ideas must be evaluated in terms of their practical consequences. A principle is an idea that explains a fundamental aspect of reality and is used as a basis for thinking and as a rule for choosing among alternative solutions to a problem. Pragmatism divorces the choice of solutions from principles and offers no practical guidance.

Morality has been defined by philosopher Ayn Rand as a code of values to guide one’s choices and actions in order to maintain and further one’s own life (Ayn Rand, “The Objectivist Ethics,” The Virtue of Selfishness, New York: New American Library, 1970). Values are goals to be achieved. The fundamental values of the Code are serving the public interest, honoring the public trust, and demonstrating a commitment to professionalism; and it details rules of conduct to achieve these values. But this is an appeal to the collective well-being of the “group,” not to the maintenance and furthering of one’s own life. The Code’s fundamental premise of protecting the public interest is also vacuous since there is no such entity in reality as the “public,” but only individual participants in economic activity, each of whom has his or her own interests which can and often do conflict.

For that reason, the Code cannot offer a principled code of values. It inevitably leads to Pragmatism. But Pragmatism’s fundamental value of achieving practical consequences is also vacuous since it ignores an answer to the question, “Practical to whom and for what?” Based on what standard? Collective well-being, the client’s well-being, the investors’, the employer’s, the lender’s, the government’s, the accountant’s? Failure to integrate values and practical consequences or practical consequences and values produces the same result: moral chaos.

One can readily see that neither the Code nor Pragmatism offer the accountant practical guidance. Given this lack of guidance, we will consider what happens in practice.

Why do people become accountants? Probably for as many reasons as there are accountants, but each have some things in common: an affinity for the work, a desire to master complexity, a love of working with numbers, a desire to make a difference, an attraction to the perceived moral element and a desire to make an honest and lucrative living.

What do people who become accountants do? They study to master the material, they take the ideas and mandates seriously, they open up shop or join someone who has and they get to work – and encounter conflicting mandates and perhaps a call to self-sacrifice.

Let’s look at an example scenario:

A public accounting firm performs audits of U.S. Department of Housing and Urban Development (HUD)-insured low-income housing projects. The project owner is a limited partnership with a general partner and twenty limited partners. It has obtained a HUD-insured mortgage loan from a lender with a low interest rate. It has agreed to comply with the lender’s terms and with HUD regulations. HUD’s regulations require the project owner to provide safe, affordable housing and above all to safeguard HUD’s collateral which consists only of the real estate. This is non-recourse debt which means if the project owner defaults on the loan, HUD’s only recourse is to foreclose and acquire ownership of the real estate. HUD is not in the real estate rental business. To safeguard its interests, and those of the taxpayer, it has a boatload of regulations with which the project owner must comply.

The regulations include a requirement to fund a reserve for the replacement of property; a requirement to maintain the property in a clean and safe condition; a limitation on owner distributions subject to surplus cash, as defined by HUD, and the requirement to submit annual audited financial statements. These are just the tip of HUD’s iceberg.

Some of the oldest HUD projects in the country are in the northeast United States, where I practiced.  Over the years, many of these projects have devolved into hellholes. Crime and vandalism are rampant and vacancies abound as prospective self-respecting low-income tenants seek and often find alternatives. The result is revenue loss sometimes so severe that the project owner is at risk of defaulting on its debt-service and reserve-funding and seldom has sufficient funds available to repair or replace all of the vandalized property.

If the project owner defaults on the loan by falling behind on its loan payments or has outstanding property maintenance deficiencies, the project owner is not permitted to take distributions, but in many HUD programs is required to fund the shortfall, without repayment, unless with HUD’s approval. It’s a sad state of affairs. One can’t fault HUD for safeguarding taxpayer money with rigorous oversight; if it failed in this, we’d complain it was squandering our tax dollars. And one can’t fault project owners for failures emanating from circumstances beyond their control.

Then, it’s time for the annual audit. The auditors perform their procedures and conclude the financial statements are fairly presented in all material respects; however, they note certain non-compliance matters and cite the project for non-compliance and deficiencies in their compliance and internal control reports. HUD comes down on the project owner like a ton of bricks: demands for explanations, submission of corrective action plans, threats of significant monetary penalties. The project owner fires the auditors.

Some auditors, anticipating the possible or probable loss of the client, might turn a blind eye to minor infractions, reporting only those that must be reported. For example, HUD doesn’t need the auditor to report unauthorized distributions (although it’s required); its software is programmed to determine that. But if there are holes in the walls in apartment 5-C or the tenant in 6-D ripped the bathroom sink off the wall, and repairs have not yet been completed, the auditor might chance that the repairs will be completed before the next HUD inspection and choose not to report the deficiencies. After all, the auditor has to make a living, right? Can’t very well do that by being unreasonable and acquiring a bad reputation with clients. Another auditor will follow the rules to the letter and live with the results – and feel like a fool for being honest.

The above scenario presents several values, i.e., goals to be achieved: the general partner’s goals of fulfilling its fiduciary duties to the partnership and its limited partners, honoring its contractual responsibilities to the lender and complying with HUD’s regulations; the general partner’s and limited partners’ goal of receiving a return on their investments; the lender’s goal of receiving repayment of the loan and a return on its investment; government’s goal of providing affordable housing; HUD’s goal of effectively administering the program; the tenants’ goal of occupying clean, safe, affordable housing; the accountant’s goal of recording, presenting and reporting the financial position and results of operations of the project; and the profession’s goal of protecting its credibility.

At least theoretically, these goals are congruent. But in reality, two or all of them might conflict. If the project has suffered such severe revenue loss that it is unable to comply with all terms and regulations, the general partner will have defaulted on its fiduciary responsibilities and its compliance with laws and regulations; all of the investors will fail to obtain an acceptable return on their investments; government’s goal of providing affordable housing will be impaired; HUD will not have achieved effective administration.

Threats to the achievement of its values provides an incentive for each stakeholder to take action in its best interest and that action might be at the expense of the other participants. Failure to make necessary repairs would violate both the terms of the loan agreement and HUD’s regulations. The loan would be in technical default and the partners would be precluded from taking distributions. This could lead the limited partners to file an action against the general partner for breach of fiduciary duty. Further, the lender could file an insurance claim with HUD. This could lead HUD to assess monetary penalties against the project owner and take control of the project. This would further erode the partners’ equity. The prospect of such outcomes could cause the general partner to pressure the accountant not to report the deficiencies.

How is the accountant to resolve the conflicts? The Code states “protect the public interest.” Who, here, is the public? Clearly, the interests of these participants conflict and resolving the conflicts might require one or more of them to “sacrifice” their interests to one or more of the others. But the Code holds only the accountant responsible to achieve resolution of those conflicts in order to achieve collective well-being. Pragmatism states “choose the action that results in the most practical consequence” – practical for which participant? Neither the Code of Professional Conduct nor the philosophy of Pragmatism offers a guide to resolution.

How is the accountant to resolve the conflicts? The Code states “protect the public interest.” Who, here, is the public? Clearly, the interests of these participants conflict and resolving the conflicts might require one or more of them to “sacrifice” their interests to one or more of the others. But the Code holds only the accountant responsible to achieve resolution of those conflicts in order to achieve collective well-being. Pragmatism states “choose the action that results in the most practical consequence” – practical for which participant? Neither the Code of Professional Conduct nor the philosophy of Pragmatism offers a guide to resolution. What will? The answer begins with a question: what is the appropriate action for the accountant/auditor to take and why?

If one begins, not with the Code’s fundamental premise of protecting the public interest, but with the accountant’s objective of accurately recording, presenting and reporting economic activity, one recognizes the value and utility of objectivity, independence and integrity in achieving this objective. One cannot achieve the objective without identifying, evaluating and responding based on – the facts. To fail in any one of these is to fail to achieve his or her goal and value.

`The purpose of ethics is to guide one’s choices and actions in the face of alternatives so that one can accomplish one’s goal of achieving one’s values. Ethics formulates principles to guide one’s choices and actions in all areas of one’s life, whether professional or personal. Ethical principles are relevant to all decision making. When faced with the ethical conflicts we are discussing here, the accountant must adhere to the ethical principles of objectivity, independence and integrity if he or she is to accomplish the objective of accurately recording, presenting and reporting economic activity or, indeed, if he or she is to achieve any value. In any given situation, one cannot adhere to the facts only when one likes them; that’s not objectivity, it’s subjectivism. One cannot rely on one’s own judgment only when one expects agreement; that’s not independence, it’s psychological dependence on the minds of others. One cannot be honest only when it is convenient; that’s not acting with integrity, it’s simply dishonesty. Emotional subjectivism, psychological dependency and dishonesty divorce one’s mind from the facts of reality and guarantee failure to achieve one’s values; if one’s ultimate objective is to live a full, productive, effective and happy life, one’s ability to do so is seriously impaired.

The importance of thinking in principles applies to all the participants in economic activity, not just the accountant. To the extent that any of them fail to adhere to ethical principles, the consequences are theirs to bear. The accountant is not responsible to achieve, and cannot achieve, their collective well-being. In the scenario presented above, conflict is framed as self against others: either each participant sacrifices his interests to others or others’ interests to himself. But there is no inherent conflict of interest here; conflict doesn’t arise until at least one participant fails to adhere to ethical principles and attempts to distort the facts.

In our example above, the fact is the project did not generate sufficient funds to enable it to comply with all terms and regulations. This fact cannot be wished out of existence. If the general partner pressures the accountant not to report this fact and any resulting deficiencies, and if the accountant accedes, then both are guilty of moral failure. The general partner’s fiduciary duties and the accountant’s professional and contractual obligations include alerting the limited partners, the lender and HUD to the actual situation. Failure to do so is fraud. Fraud is the attempt to gain an unearned, undeserved value by means of deception. It is the attempt to deny that what exists, exists; that what exists is what it is; and that one knows it. Fraud is self-abnegation. Engaging in it divorces oneself from what exists, and blinds oneself to identifying and evaluating what exists, and acting accordingly. One cannot maintain or further one’s own life by denying oneself. This is the ultimate meaning of moral failure. Only by adhering to the ethical principles of objectivity, independence and integrity by identifying, evaluating and reporting the facts can the general partner and accountant act in their own self-interest to maintain and further their own lives.

In our example above, each of the parties involved has rights and each have assumed risk. Anticipated outcomes are not guaranteed. If, as a result of poor cash flow, the limited partners do not receive their expected distributions, or the lender does not receive timely loan payments, or HUD’s collateral is placed at risk, or the tenants’ repairs are not completed timely, they are bearing the consequences of their individual decisions to engage in this particular economic activity (involvement with this project). Their interests are not in conflict and they are not “sacrificing” their interests to the other participants if they fail to achieve their objectives. Failure to recognize this fact and assume responsibility for their own decisions to assume risk is to be guilty of moral failure because it is to be non-objective: to ignore the fact of risk. Failure to achieve their objectives entitles each of them to pursue whatever recourse is available under their contractual relationships with the others, but if the general partner and accountant have alerted them to the risks, they are not entitled to demand the accountant resolve the issue in their favor, or everyone’s favor, for that matter.

For guidance in this situation, the Code preaches the correct virtues (objectivity, independence and integrity), but for the wrong reason (protecting the public interest) and is not accepted because its advice seems impractical. Pragmatism preaches the wrong “virtues” (subjectivism, psychological dependency and dishonesty, i.e. whatever works) and is accepted because superficially its advice sounds plausible and practical. Both the Code and Pragmatism offer a false dichotomy: moral reasoning vs. practical reasoning. Moral reasoning is defined by both as fulfilling one’s duties to others. Practical reasoning is defined by both as fulfilling one’s duties to oneself. Both view the two as antithetical. Both are mistaken.

Philosopher Ayn Rand stated, “The moral is the practical.”  What she meant is that human beings need moral principles to guide their choices and actions in the face of alternatives, that they have no choice about the necessity to make choices, that their only choice is what to choose, that the choices they make should be those that will enable them to maintain and further their own lives – a life proper to a human being. Not a life based on wishful thinking or theft or fraud, but one based on conscious identification of the facts of reality (i.e. discovering what is true) and applying that knowledge to productive achievement of life-sustaining values. One cannot create life-sustaining values by engaging in wishful thinking or theft or fraud; at best one might succeed in temporarily acquiring values created by others, but such actions will not sustain one over a lifetime and can hardly be said to be practical. We can understand from this analysis that there is no dichotomy between moral reasoning and practical reasoning. We can also understand the essential characteristic of moral reasoning or practical reasoning is not who is or should be the beneficiary of the action. The defining characteristic of moral and practical reasoning is what are the values and actions required by a proper human life.

The answer, then, to our question “why is the accountant/auditor sometimes complicit in corruption, fraud and failure” is clear:

It is not because businessmen or auditors are “selfishly” immoral, but because they often adhere to a mistaken idea of what is morality; morality is and properly should be selfish. It is the lack of commitment to achieving objective, life-sustaining values that allows any participant in economic activity to take actions that ultimately endanger his or her ability to live a full, productive, effective and happy life.

It is not because there is not enough government oversight. Enforcing the Code’s premise of “protecting the public interest” at gunpoint has protected and will protect no one.

It is not because firms sometimes respond to pressures like implementing an expensive quality control system and adequately training staff while under fee pressure and workload compression by failing to do either.

It is because many accountants and auditors have accepted a moral standard that is impossible to achieve for a beneficiary that doesn’t exist in reality (protecting the public interest) and they’ve accepted the equally false alternative of abandoning a beneficiary that does exist (the individual agent) by adopting a moral standard that fails to achieve life-sustaining values (pragmatism).

The answer to our question “what action should the accountant/auditor take” when confronted with ethical conflicts is also clear. If, for example, the accountant/auditor is faced with the alternatives of (1) protecting the client’s confidentiality, (2) complying with regulators’ mandates to the contrary, or (3) economic suicide, he or she must accept that protecting the client’s confidentiality does not include helping the client to commit fraud by failing to alert the other participants of the actual situation and thereby failing to comply with laws and regulations. He or she must accept that if the client refuses to cooperate, this choice is the client’s right and the consequences are the client’s to bear. He or she must accept that if the client threatens to fire the auditor for reporting the actual situation, this, too, is the client’s right and the accountant can either attempt to educate the client about the reasons full disclosure is required or terminate the relationship.

If his or her ultimate objective is to live a full, productive, effective and happy life, one of the requirements is fulfilling his or her role and value in economic activity by accurately recording, presenting and reporting economic activity based on his or her identification and evaluation of the objective facts. Adhering to the ethical principles of objectivity, independence and integrity will enable the accountant/auditor to achieve the objective and restore the value of accounting and auditing unsullied.

Epilogue

This article was written originally in 2015 but its relevance continues today because as 2016 and 2017 PCAOB Inspection Reports reveal, public companies’ audits are still coming up short even though some improvement has been noted.

 

Acknowledgments

The author would like to thank David Kelley, Vinay Kolhatkar, and Walter Donway for comments made on earlier drafts.

 

 

(Visited 180 times, 1 visits today)
  • lawlesslatvia

    Very interesting! I have a big problem with auditors because of the modern concept that fraud is ok and should be overlooked when it serves the common good to do so. Specifically, I was whistleblower in a Russian Mafia fraud in which $2 billion was stolen from taxpayers in Latvia. EY, Deloitte, and Eurostat (European Commission) have been fighting me to cover-up the fraud for years, thus allowing the fraudsters to run free with the loot. And, although EY/Deloitte/Eurostat refuse to talk about this directly with me, I have heard indirectly from people that can talk with the auditors that they think I am a jerk for trying to expose the fraud because Latvia is a poor country and I will hurt the Latvian people if I expose the fraud. Seriously, they are arguing that a fraud against poor people should be covered-up and the culprits should escape because this somehow helps the poor people.

    • Donna Paris

      I can only imagine what kind of horror you, who value truth and honesty, are experiencing and I wish I could offer some effective prescription, but all I can suggest is that you do whatever your conscience directs you to do because at the end of the day, that’s all each of us has (our conscience).