Main Body

Foundations of Professional Ethics for Accountants

Trust is the cornerstone of the accounting profession.  Individual ethics form the foundation of our character, relationships, and roles in life. Ultimately it is our individual ethics that develop the ethical foundations of our businesses, government, and other important institutions.  This chapter is designed to give you an understanding of professional ethics for accountants.  In later chapters we will evaluate the ethical codes of conduct that have been published by the California Board of Accountancy and by various professional associations.  Before exploring the unique ethical responsibilities of accountants, we will explore some fundamental theories of ethics.


The Principle of Utility

The principle of utility basically provides that when you are faced with a choice, you should choose the action that creates the most overall happiness.

Jeremy Bentham
Jeremy Bentham

When evaluating your choices it is important to anticipate the outcomes of each choice.  You would then choose the alternative that generates the most happiness for all of the people affected.  It is not important that the happiness be evenly distributed.  One person may gain greater benefits than other people.  Some people may gain no benefit, and some people may actually experience a loss.  The principle of utility simply seeks to provide the most overall benefit.   Philosopher Jeremy Bentham is generally credited as the most influential contributor to the theory of utility.

Most of our ethical decisions will require subjective judgments.  This causes some complication for the principle of utility.  When using the principle of utility, the person making the decision must be impartial and not have their judgment impaired by personal interests.  As we will later learn, independence is a core principle for accountants.

Case in Point – Greenfield’s Landscaping Company

Assume you are the controller for Greenfield’s Landscaping Company.  Greenfield’s has a long successful history and employs 150 people.  The company is generally well managed, employees are happy, and pay levels are adequate for employees to support their families.  Business has been slow due to a downturn in the economy and profits have dropped off.  The company applies for a working capital loan each year to provide cash during the slow winter months, and then repays the loan during the busy spring and summer season.   You have expressed concern to the company president that the bank may not be willing to approve a working capital loan due to the company’s declining profits.

The company president indicates that without the loan it will be necessary to lay off 60 good employees until business picks up.  He asks you to make the profits appear higher to ensure that the bank will approve the loan.  You recognize that manipulating the financial statements will create the most happiness for these 60 employees and their families, but you recognize that there may be other drawbacks to this decision.

The concept of utility becomes more complex when you attempt to give different weights to each outcome.  For example, does the outcome to one person outweigh the outcome to another?  Will we maximize total utility or average utility per person?  Will our decision be based on only certain people or values?

Since utilitarianism is focused on the outcome and consequences of our decision, it can also be referred to as consequentialism.


The Principle of Justice

John Rawls
John Rawls

Utilitarianism/consequentialism is focused on the result of our decision, rather than on the constraints, rights, and duties that affect the decision.  Philosopher John Rawls contended that the primary argument against the principle of utility is the potential lack of justice because the happiness is not equally distributed among everyone who will be affected by the decision.  Some people may gain greater happiness at the expense of others.  Some members of the group may even suffer as a result of the decision.  The principle of justice considers the constraints, rights, and duties of the decision maker.  In his book, A Theory of Justice, Rawls created what he referred to as the “first principle of justice,” which states:

“Each person is to have an equal right to the most extensive basic liberty compatible with a similar liberty for others.”

Essentially, Rawls was arguing for equality, and he was specifically concerned with the least-advantaged citizens.   Consider the case of Healthy Hannah.

Case in Point – Healthy Hannah

Hannah is a healthy 23 year-old woman who visits a hospital emergency room with severe head injury.  The doctors determine that they can treat Hannah and she will fully recover in a few months.  The cost of treating her will be about $250,000.  However, for a smaller cost of about $100,000 the doctors would let Hannah die in the hospital and then harvest her vital organs to benefit many other people.  While the loss of Hannah would be tragic, many other lives could be saved with the organ donations.

  1. How would you determine what to do using the principle of utility?
  2. How does the concept of justice apply to this decision?


Kant and the Categorical Imperative

Immanuel Kant was an 18th century German philosopher.  Kant developed several principles that can be used when making moral or ethical decisions.  His philosophy, known as the categorical imperative, is based on the concept of duty to one central moral value.  To implement the categorical imperative, Kant suggests the following:

Immanuel Kant
Immanuel Kant

Universalize the principle.  A principle used infrequently may seem to generate the greatest happiness.  For example “I will lie on my application to get a job” may result increased happiness for the employee, and the employer may be quite delighted with this person as an employee.  However, Kant suggested that the principle should be “universalized” as to what would happen if everyone acted in the same manner.  If everyone lied on their application, there would be no net increase in happiness because employers would no longer trust or use an employee application.  Therefore lying is not ethical, because when “universalized” it does not create more happiness.  Kant’s categorical imperative suggests that that a choice is moral only if it can be universally used by everyone in similar circumstances.

Humanity.  Kant stated that people should always be kept in the highest regard when making decision. People are not a means to an end.  Rather they are the “supreme limiting condition.”  In the case of Healthy Hannah, the principle of utility might suggest that the doctors should harvest Hannah’s vital organs to create the most overall good. However, Kantian ethics would require that Hannah be treated with the greatest consideration and that we respect her humanity.  Her life is a “supreme limiting condition.”

Kant’s views differ from utilitarianism.  Whereas the concept of utility focuses on the outcomes or result of decisions, by “universalizing the principle” as espoused by Kant, the decision is focused on the duties, rights, and constraints affecting the decision.  For example, in the case of Healthy Hannah above, the decision whether to harvest her organs or to save her life is constrained by law and duty to professional standards.  Even if the hospital and doctors were convinced that harvesting Hannah’s organs created the most overall good, they are bound by law, professional standards, regulations, and other constraints.  This theory of ethics is also referred to as deontology.


It’s All About Character

Deontology and consequentialism focus respectively on the inputs and outputs of an ethical decision.  There is a third theory of ethics that focuses on virtues such as honesty, integrity, dependability, selflessness, and other virtues and character traits that are valued by society.   A virtue is not an action; it is the moral character of the person.

Case in Point – Faithful Realtor Matthew

Matthew, one of the most active congregation members in the local church recently gave a presentation on “the importance of honesty.”   You have observed that Matthew does seem to be a very honest person, he says the right things, and often expresses his faith.   Recently you became aware that Matthew attends church primarily to find clients for his business and that his faith is weak.

  1. Matthew does everything required to show his faith. Would you say he possesses the virtue of faith?  Why or why not?
  2. Would you say Matthew possesses the virtue of honesty? Why or why not?


Friedman on the Primary Responsibility of Business

Milton Friedman was a Nobel Laureate in economics.  One of his philosophies was that the primary responsibility of business is to maximize profits, while complying with

Milton Friedman
Milton Friedman

the laws and values of society.  Friedman believed that for a business to spend more than required by law or custom would reduce profits and thereby violate their primary responsibility to maximize profit.  That is not to say that Friedman believed that businesses should act in an unethical manner.  He believed that business should exercise a level of ethics required by law and expected by society.  His principle is better understood in terms of social responsibility.   For example, an oil refiner is subject to various environmental regulations.  Beyond the legal requirements, citizens have an expectation that the refiner will not create an unhealthy environment in the community. Friedman suggests that a business should meet these responsibilities and expectations.  Beyond that, a business would spend extra money on these goals only if they believed it would generate increased profits through goodwill.

Many in business point to Friedman’s premise that the sole purpose of a business is to make a profit.  But the second half of Friedman’s theory is essential that a business must operate within the laws and values of society.  Essentially, Friedman believed that capitalism was the best economic model to create prosperity for citizens, but business leaders must operate with a sense of ethics that reflect the values of society.


Applying Ethical Principles

When faced with a personal or professional decision, we can apply the principle of utility and the categorical imperative to help us make ethical decisions.  We can use the principle of utility to ensure that the choice we make generates the most overall good.  However, we must make a decision that respects all people, does not cause injury or unhappiness to one or more people, and is within our legal and professional duties.  This may best be summed in the words of Hippocrates to “…make a habit of two things — to help, or at least to do no harm.”

While we can use the tools provided by traditional ethical theory, we should strive to the virtues of our profession.  The various codes of conduct for accountants and auditors espouse integrity, objectivity, selflessness, independence, confidentiality, and commitment to high levels of technical skill and professionalism.   Virtues are much more than actions – they are the essence of character.

Using Friedman’s belief that business should do what is required by law and expected by society can be applied to our service as professional accountants.  We are regulated by state laws and by various codes of ethics.  More important are the expectations of our clients and the public.  Our clients expect high levels of integrity, honesty, and reliability.  They expect that our actions are based on their interest, and not our own self-interest.

As accountants, we must exercise a high degree of ethics.  Our duty is to the public – those people and institutions that use the information we generate and the opinions we offer.  Our individual reputations and the reputation of our entire profession are based on the public’s ability to trust our information and our opinions.


Expectations and Credibility Gaps

The American system of financial reporting, audited financial statements, and oversight by the Securities and Exchange Commission is designed to provide the public, investors, and creditors with reliable information about public companies.  However, there have been a series of high profile cases of fraudulent financial statements including Enron, WorldCom, Rite-Aid, Tyco, HealthSouth, Adelphia, and more recently the Bernard Madoff $50 billion Ponzi scheme.  Similar scandals have also occurred in other countries with supposedly strong financial reporting requirements.  To some extent, these scandals were amplified by auditors which compromised their independence and objectivity for profit.  These cases are limited, with most corporations issuing correct financial reports and auditors that exercise appropriate professional skepticism.

These high-profile fraud cases have caused the public to expect that most financial statements are erroneous.  The difference between how poorly investors perceive financial reports and the actual higher reliability is known as the expectations gap.  Investors, creditors, and the public expect far less than they are actually getting.  The investors, creditors, and employees of companies that issue fraudulent financial reports always lose substantial amounts of money.  Lawsuits follow, but few of these losses are ever recovered.  As a result, there has been substantial new regulation of corporations and auditors in order to restore the reliability of financial statements.

The expectations gap for financial statements, combined with other corporate behavior, has caused the public to have limited trust of corporate executives.  The overall mistrust of corporate executives is known as the credibility gap.  The credibility gap has resulted in boards of directors exercising more oversight of executives.  The number of CEO’s fired by their board has increased substantially in recent years.  Virtually all large corporations now have ethics policies and codes of conduct, an ethics officer, and a system of reporting ethical violations.

The Sarbanes-Oxley Act of 2002, also known as SOX or SarBox, was enacted to restore credibility to corporate governance and the accounting profession.  The Act places substantial new requirements on publicly-traded corporations and creates a new layer of oversight for the accounting profession.  Many critics argue that SOX was a knee-jerk reaction, provides excessive regulation, and places large burdens on smaller corporations.  As a result of these criticisms Congress has modified the requirements of SOX as they apply to small and medium sized companies.

The Great Recession of 2007-2009

The primary cause of the “great recession” was a collapse in housing.  Could the housing collapse have been avoided?  There is plenty of blame to go around.

  • The U.S. government required lenders to make housing loans to people who traditionally could not afford to purchase a home
  • The lenders were happy to take advantage of the profit opportunities by making loans to people that could not afford the payments.
  • Potential borrowers overstated their income on their mortgage applications, with encouragement from the loan officers. This was felony loan fraud.
  • Loan officers encouraged borrowers to overstate their income.
  • The lenders sold these loans to FNMA, FHLMC, Goldman Sachs, etc. who then resold these in packages to unwitting investors, while failing to disclose to investors that these were high-risk securities.
  • The credit rating agencies gave the highest ratings to these packaged mortgages. Investors relied on these inaccurate credit ratings.
  • During the collapse, banks were hesitant to work with defaulting borrowers.
  • Some borrowers who could afford their mortgage payments opted for “strategic defaults” by walking away from their obligations because it made financial sense for them, personally.

These are just the major factors that caused the housing collapse and the great recession.


How Sarbanes-Oxley (SOX) Changed Auditing

Prior to SOX, the accounting profession was self-regulated.  The Securities and Exchange Commission (SEC) had authority to implement accounting and auditing standards, but generally allowed standards to be set by the Financial Accounting Standards Board (FASB) and the American Institute of Public Accountants (AICPA).  As long as FASB and AICPA seemed to set the appropriate standards, the SEC was inclined to let the profession be self-regulated.  SOX created a new government oversight agency, the Public Company Accounting Oversight Board (PCAOB).  PCAOB has authority to issue standards, rules and regulations and to provide additional oversight.

Another important provision of SOX is Rule 404, which requires that auditors spend additional time on internal controls.  Rule 404 has caused substantial increases in audit hours, costs, and fees.  During the several years following the implementation of Rule 404, accounting firms struggled to hire the many new employees that would be necessary to accomplish this new work.  Rule 404 and this extra cost are also the source of the primary complaint that SOX is a burden to small business and may be changed by Congress.

Another important change is that firms that provide audit work are now much more limited in the additional services that they may provide.  Many of these additional services were seen as undermining the auditors’ objectivity and independence.  This has resulted in larger firms shedding some additional services.  Those services have been picked up by other firms.


The Ultimate Price of Ethical Violations

The debacle of Enron, WorldCom, and Arthur Andersen demonstrates the ultimate price paid for their ethical violations.  Arthur Andersen, once known as the most conservative and well-respected accounting firm, is no longer in business.  The actions of a few Andersen employees resulted in a felony conviction, revocation of the firm’s CPA license in every state, and the effective closure of the firm.  Enron collapsed and is a shadow of its former size.  WorldCom recovered from their bankruptcy, became a much smaller company, and changed their name to MCI.  In 2006 MCI was purchased by Verizon.  The collapse of these firms is a reminder to accountants that objectivity and independence are the cornerstones of the profession and the consequence of failed ethics affects not only the accountant involved, but many employees, investors, creditors, and society in general.


Questions for Research and Discussion

1. From the case in the chapter of Greenfield’s Landscaping:

  • What factors would you consider in making this decision?
  • Using only the principle of utility, what decision would you make?
  • Considering the principle of justice, how would this change your decision?

2. From the case in the chapter of Healthy Hannah:

  • What factors would you consider in making this decision?
  • Using only the principle of utility, what decision would you make?
  • Considering the principle of justice, how would this change your decision?

3. From the case in the chapter of Faithful Realtor Matthew:

  • Would you say he possesses the virtue of faith? Why or why not?
  • Would you say Matthew possesses the virtue of honesty? Why or why not?

4. Do you agree or disagree with Milton Friedman’s philosophy? Please explain.

5. In your own words, compare and contrast the expectations gap and the credibility gap.

6. Could the great recession have been avoided if each of the parties that contributed to the housing collapse had practiced the ethical principles described in this chapter?

  • Could the great recession have been avoided if only one of the groups had used sound ethical principles?

7. Do you believe that Sarbanes-Oxley will prevent another major financial fraud? Please explain.

8. Research the philosophy of Thomas Hobbes, specifically on his views about the nature of humans and their self-interest.

  • Do you agree with Hobbs?
  • Why or why not?



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Professional Ethics for Accountants Copyright © 2019 by Anne and Rob Diamond is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License, except where otherwise noted.

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