Sample Case Study on Ethics
Case Study on Ethics
An effective code of ethics succeeds in influencing people to behave ethically. In contrast, an ineffective code of ethics serves little purpose and merely provides an illusion that the employees or profession would actually abide by the code. This case study will first discuss an appropriate conceptual framework that guides the design of auditors’ codes of ethics. An assessment of the merits and flaws of the accounting profession’s Code of Professional Conduct and Ethics will then be made. Recommendations will also be proposed to address the highlighted weaknesses. Lastly, prior researches are reviewed to determine the factors that influence such codes in general.
Profession bodies should integrate both principles and specific rules, ensure that specific rules are relevant in light of new developments in the profession and that compliance does not impose excessive cost on the auditors.
Comprise Both Principles and Specific Rules
Codes of ethics for auditors should consist of both principles and specific rules. Principles complement specific rules by alerting auditors to the true meanings and intentions behind the specific rules; while specific rules clarify fundamental principles by highlighting instances of problem situations (ICAEW, 2001).
Codes of ethics for auditors should comprise all of the following principles:
- Public Interest
- Professional Competence and Due Care
In Tune with Developments in the Profession
Principles are normative and thus do not change with circumstances. However, specific rules, which represent adherence to certain principles in particular situations, should be regularly reviewed and amended in light of new developments in the profession. A stagnant code of ethics is unlikely to be relevant in providing useful guidance to auditors in today’s dynamic environment.
Entail Reasonable Cost of Compliance
The principle of Public Interest dictates that an auditor should subordinate his personal interests to that of the public. However, in designing and developing codes of ethics, it has to be ensured that compliance does not entail such excessive cost that profitable commerce by auditors is no longer possible.
Critical Assessment of Code of Professional Conduct and Ethics (3rd schedule, PAB Rules)
This section discusses the strengths and weaknesses of the Code of Professional Conduct and Ethics (The Code).
The Code provides comprehensive guidance with regard to auditors’ independence and is up to date with developments in the profession.
Comprehensive Guidance on Auditors’ Independence
Recent amendments to The Code introduced five supplementary principles to the fundamental principle of Independence. These supplementary principles clarify the fundamental principle of Independence by highlighting to auditors that impairment to independence occurs whenever an auditor acts in any way (or is perceived to have behaved in any way) that is affected by self-interest, self-review, advocacy, familiarity and/or intimidation threat. Appreciation of the general circumstances under which independence can be impaired will greatly facilitate auditors in observing the fundamental principle of Independence.
Up to Date with Developments in the Profession
Apart from auditing financial statements, auditors and accounting firms are increasingly providing a wide range of other services such as internal auditing and management recruiting. The Code has kept pace with such developments in the profession through the recent amendments. Recognizing that some of these services would inherently impair auditors’ independence, the amendments introduced specific rules that prohibit auditors and/or accounting firms from rendering certain non-financial statements audit services such as specialist valuation services and corporate finance services to audit clients.
The Code does not adequately match specific rules to principles, imposes a high cost of compliance on accounting firms and discriminates against stakeholders in private companies.
Inadequate Matching of Specific Rules to Principles
The Code contains all principles mentioned in 1.1 and specific rules. However, at times, it can be difficult to fathom which fundamental principle (or supplementary principle) provided the motivation for a particular specific rule (e.g. Paragraphs 6(2) & (3)). To the extent that auditors do not understand why certain specific rules are set, ethical behaviour may degrade to a rule-following game.
It is recommended that principles (fundamental or supplementary) of which specific rules represent observance of be explicitly stated in The Code. This matching of specific rules to principles will facilitate auditors in understanding the spirit of these principles. Enhanced understanding of principles will alert auditors to instances of misconduct that are not specified in the specific rules contained in The Code.
High Cost of Compliance
Compliance with Paragraphs 2B(2), 2F(2) and 2F(3) requires an accounting firm to constantly monitor the economic interests of all its employees and affiliated entities. This entails significant time and manpower.
Auditors’ independence is a product of perception. For instance, when an audit client’s equity share capital is large, the public may still consider independence to be impaired even though the accounting firm’s aggregate economic interest in the client’s equity share capital is only 1%. The public may not perceive the auditors as independent even if they complied with Paragraphs 2B(2), 2F(2) and 2F(3). Therefore, such high compliance costs may not be justifiable.
Hence, it is recommended that the 5% restriction in the above-mentioned paragraphs be lifted. It is also suggested that existing disclosure in the auditor’s report (as provided for under Paragraph 2B(4)) be augmented by disclosure of economic interests held by affiliated entities, auditors and staff members in any business ventures with any client party (as defined in Paragraph 2F(4)). This way, shareholders get more information to form their perceptions on auditors’ independence. To the extent that a company’s shareholders do not perceive the current auditors as independent, the shareholders can elect to change auditors at the company’s Annual General Meeting.
However, as disclosure is ex post, the effectiveness of this recommendation in terms of protecting public interest may be curtailed.
Codes of ethics and professional conduct are essentially normative. Auditors may not behave as the codes prescribe. To understand what factors enhance or detract the effectiveness of codes of ethics in promoting ethical behaviour, attention is diverted to empirical research on this line of inquiry.
Review of Prior Research Studies to assess Factors that Influence the Effectiveness of Codes of Ethics
Ford and Richardson (1994) found evidence of a consistent relationship between the mere presence of codes of ethics and ethical behaviour. However, Ferrell and Gardiner (1991) indicated that codes are inadequate to ensure ethical decision-making. Additional factors must be present to promote ethical behaviour. Given the mixed research findings, it is essential to further investigate the influence of factors below.
Fundamental psychological theory suggests that personality influences predicts what a person will do during a situation (Hogan, 1996, 469-470). Hence, one’s character often determines his actions in an ethical dilemma. If an accountant is a conservative, rule-abiding person, he/she will probably follow the code of ethics strictly.
Pressure from Superiors
Code efficacy in promoting ethical behaviour can be undermined by pressure from unethical superiors. DeZoort and Lord (1994, 1) found that “auditors who received inappropriate instructions” from superiors tend “to violate professional norms or standards” compared to those without pressure. This is unsurprising, as subordinates will not want to go against superiors controlling their rewards and punishment. Moreover, subordinates may perceive superiors as givers of good guidance and negate to question them.
A special case of undue pressure from superiors is that of internal auditors. Reynolds (2000) noted that internal auditors often face the contradictory situation of simultaneously being independent and at the same time loyal to their employing organizations. When they detect management’s wrongdoing, their loyalty may inhibit them from reporting it to the board of directors. Such conflicts of interest may jeopardize the codes’ effectiveness.
Tucker et al. (1999), Epstein (1979) and Murphy (1988) emphasize the importance of developing a culture that supports ethical conduct and debate (Grimshaw, 2001, 7). Cushing (1999, 2) suggests “cultivating a strong moral climate”. With strong ethical cultures, the code is constantly being kept alive in employees’ minds. Management must take the lead and be a good role model and code administrator.
In the paper of Farrell, Cobin and Farrell (2002, 5), the research results concluded that high mainstreaming, high consistency and high congruence corporate cultures increases the effectiveness of codes of ethics.
Top Down Communication
Bowman (1981) noted that many companies referred to codes of ethics as a framework for guiding professional ethical behaviours in their organizations. Nevertheless, a crucial supporting factor is management’s communication of these codes. Otherwise, employees may not practise them as they are unaware of the codes’ existence. Furthermore, Somers (2001) found that the mere adoption of a corporate code of ethics is not helpful in detecting unethical activities among employees. Managers must ensure that employees understand the same ethical guidelines by communicating it to them.
Rewards and Penalties
James (2000, 47) noted, “Ethical behaviour should be rewarded, while unethical behaviour should be punished”. However, it seems impractical and costly to give a bonus every time someone behaves ethically. Perhaps rewards should be intangibles such as pride, or gaining a good reputation to aid future promotion. However, the longer the interval between the reward and the ethical act, the more ineffective the reward is in promoting ethical behaviour. Another approach suggested by James (2000) is to avoid rewarding undesirable behaviour. Since Brooks’ (1989, 34) has yet to find a big company that has successfully “implemented a rewards system for reinforcing the achievement of ethical goals”, we believe rewards have limited effectiveness. We now turn our attention to punishment.
Admittedly, the codes’ efficacy as deterrents depends on whether punitive consequences follow. Beets and Killough (1990) indicated that individuals contemplating violations are exposed to detection, reporting and sanction risks. They would consider beforehand the possibility of being discovered by someone who would not hesitate to report them. Ultimately, they must bear the brunt of the sanctions.
The study revealed that the participating CPAs and clients were unfamiliar with the code. This lowers detection risk. For reporting risk, the CPAs surveyed would report approximately half of the violations. Graber (1979) suggested that practitioners might be unwilling to report peers for fear of ruining their livelihood. Sanction risk was tested by considering what the respondents perceived of the sanctions; perceptions influence behaviour. Respondents believed that punishment would seldom result. In all, the significance of all three risks is lacking and must be increased for the code to be effective.
All the factors complement each other in enhancing the efficacy of codes of ethics. The critical issue is: how can we leverage on these factors to improve the codes’ effectiveness? Personality is extremely uncontrollable and it can either enhance or undermine the codes’ success. An extremely unethical person will still disregard the other factors and violate the code. Undue pressure by superiors is also relatively uncontrollable since it depends on the superior’s personality. At the other end of the spectrum are controllable factors like culture, communication and punishment ; it is possible to leverage on these factors to improve the codes’ effectiveness. Culture can be cultivated through time. Increasing top-down communication sends strong signals to employees. By increasing risks associated with punitive consequences, risk-adverse individuals are likely to be deterred.
The Auditors’ Codes of Ethics govern auditors and their behaviours. It is quintessential in maintaining the reputation and viability of the profession. An appropriate conceptual framework must embody the fundamental principles, be relevant in the changing environment and be economically feasible. However, even a well designed Code may be ineffective. Many factors affect the effectiveness of the Code, namely personality, pressure from superiors, corporate culture, top down communication, Rewards and Penalties. With a better understanding of these factors, we can help improve the effectiveness of codes of ethics. Ultimately, auditors can provide their services to the best of society’s interests.