BA 310 Mod 6 Ch 4 Ethics and Financial Reporting Objectives reporting 5 Explain how heuristics affect accounting 6 Describe the accounting tricks of the trade 7 Explain the concept of off balance sheet arrangements 1 Ethics and Financial Reporting 1 Explain the concept of creative accounting 2 Describe the specifics of Ponzi schemes 3 Describe potential conflicts of interest that could occur in financial reporting 4 Explain what the responsibilities of management auditors and audit committees are related to financial Accounting is a critical tool used by managers in the decision making process False or misleading numbers on financial statements is a serious breach of ethics creative accounting the deviation from the traditional methods used to interpret an accounting rule or standard Not outright fraud so it is hard for auditors to detect Examples include managers and auditors from such firms as Enron Adelphia Global Crossing Rite Air Sunbeam Tyco WorldCom and Arthur Andersen The rationality and objectivity of accounting is based on the level of rationality and objectivity of the people who interpret the rules Sometimes it is hard to see where aggressive accounting stops and fraudulent accounting starts 2 Ponzi scheme fraudulent operation where the operator an individual or organization pays returns to investors from new capital paid to the operators by new investors rather than profit earned by the operator The perpetuation of high returns requires an ever increasing flow of money from new investors to sustain the scheme Robbing Peter to pay Paul Some can go on for years before detected Bernie Madoff The fundamental flaw of a Ponzi scheme is that is never ends until the person committing the fraud is caught or disappears More and more new investors are always needed to pay off the previous investors in a never ending cycle The cascading flow of money is similar to the shape f a pyramid and hence Ponzi schemes have also been called pyramid schemes 3 The Role of Financial Reporting Primary objective of financial reporting is to provide interested parties with the ability to Make investment credit and financial decisions that relate to the firm Help the reader determine the level of cash flows for the firm Identify the economic resources and obligations to the firm Inherent subjective nature of developing and interpreting financial information opens the door for different interpretations that could lead to both unethical and illegal interpretations Five Philosophical Presuppositions of External Financial Reporting External Realism Representational Faithfulness Conceptual Relativism of Financial Reporting Schemes Subjective Judgement Commitment to Rationalism Financial reporting is governed by Generally Accepted Accounting Principles GAAP Standard framework for accounting in the US Financial Accounting Standards Board FASB Sets rules of accounting for publicly traded private companies and nonprofits Governmental Accounting Standards Board GASB Sets rules of accounting for state and local governments Federal Accounting Standards Advisory Board FASAB Sets rules of accounting for federal agencies 1 BA 310 Mod 6 Ch 4 Ethics and Financial Reporting Financial Statements for For Profit Companies Four basic financial statements Balance sheet a company s assets liabilities and equity at any given time usually on the last day of the fiscal year Income statement revenue expenses and profits over a period of time usually a fiscal year Statement of Changes in Equity Retained Earnings Statement explains the company s changes in equity throughout the year Statement of Cash Flows shows how changes in cash and cash equivalents affect cash on hand Financial Statements for State and Local Governments Three financial statements Statement of Net Assets equivalent of a Balance Sheet Statement of Revenue Expenses and Changes in Net Assets equivalent of an Income Statement Cash Flows same as for profit company No statement of changes in equity because there are no owners Financial Statements for Non Profit Organizations Three financial statements State of Financial Position equivalent of Balance Sheet Statement of Activities equivalent of Income Statement State of Cash Flows same as for profit company No statement of changes in equity The Role of Auditor audit a financial evaluation of a company s finances to determine accuracy of financial statements Determines if there is fraud Reviews how strong or weak internal controls are of entity being audited in order for a company to have an Internal controls are critically important environment that does not give employees a chance to be dishonest or commit fraud Auditors are considered the gatekeepers for the stakeholders Publicly traded companies must be audited at least once a year Non Profits All public universities and colleges in Mississippi are audited once a year Other state agencies in Mississippi are audited on a more infrequent basis No federal law requiring non profits involved in philanthropic work to be audited However many states require these entities to be audited on a routine basis Potential Conflicts of Interest Three potential conflicts of interest that can take place during the auditing process Auditor Firm conflicts of interest Since the firm is paying the auditor there is often pressure put on the auditor to provide a clean audit regardless of any concern the auditor has with the financial statement Auditors may be young and easily intimidated by older senior level executives of the firms they are auditing Shareholder Management conflicts of interest Since shareholders often do not want any negative issues related to the firm s financial statements to be made public because it will hurt the value of the stock of the company managers will often do what is necessary to ensure a clean audit including being untruthful to auditors Self Interest of Auditor Professional Standards conflict of interest Conflict of interest of the auditor if he has a financial interest in the company he is auditing such as owning stock Current Trend in Auditing Risk based audit model Assesses the level of chance of fraud by the client If the chance of fraud is low auditors do not perform the same number of tests as they would if they believe the chance of fraud was high Controversial model downfall of accounting because it relies too much on what the companies tell the auditors 2 BA 310 Mod 6 Ch 4 Ethics and Financial Reporting 4 Responsibilities 5 The Use of