The first edition of this book was sent to press in early November of 2001, just before the Enron collapse had begun to dominate the front pages of newspapers and lead stories of television news shows across America. Yet most of the problems that came to light with an accounting profession in crisis had been documented in the text. The types of problems that the Enron bankruptcy brought to the fore were nothing new. They had been talked about for years, particularly in a particularly prescient book by Abraham Briloff, The Truth About Corporate Accounting, published in 1980 by Harper and Row. Dr Briloff was at the time the Emanuel Saxe Distinguished Professor of Accountancy at the Baruch College of the City University of New York.

Briloff’s critique of the accounting profession helped us gain a focus on the important and salient issues in the ethics of accounting. Consequently the book recognized the chief ethical difficulties facing the accounting profession, and a section of Chapter ten was entitled, “The Accounting Profession in Crisis”, a name not horribly original, but extraordinarily apt given the high profile case of Enron and Arthur Andersen.

Subsequently, we asked the publishers for some time to revise the book to take into account the difficulties in accounting practices that helped contribute to Enron’s demise. Consequently there are references in the text to this most recent, but regrettably not likely the last, case of accounting irregularities.

To aid the reader sort out the facts of Enron’s collapse and Andersen’s role in that collapse, we appended a chronology of stories run in the Wall Street Journal and provided in the Journal’s online edition. Enron and Andersen made a fruitful case study for a great deal of the problems in accounting ethics. However, we removed those stories from the second edition.

Much happened in accounting since the first edition of this work was finished in 2002. In particular in the United States, Sarbanes–Oxley altered the profession and its approaches to ethical problems. It brought about FASB and the Public Accounting Oversight Board, in place of the defunct Independence Standards Board. The financial crisis of 2008 put more pressure on accountants, with claims about the pros and cons of mark to market and fair value accounting taking prominence. In the second edition we added an Afterword, where we discussed the debates over the use of fair value accounting, and principles vs rules based standards. However, we have moved on from that while preserving the section on the responsibilities of accounting firms, since those responsibilities have not changed. They simply must meet new challenges.

In the third edition we have addressed the changes in the AICPA code of ethics and in response to suggestions from people who have used the book in classes on accounting ethics, we have added, as pedagogical tools, questions about the material covered in each chapter, and cases to be discussed. Finally early on we have added an ethical sensitivity exercise that can be used both at the beginning of the book and at the end to determine the degree of one’s ethical sensitivity at the start of the use of the book and whether it has increased at the end.

“To preserve the integrity of his reports, the accountant must insist upon absolute independence of judgment and action. The necessity of preserving this position of independence indicates certain standards of conduct. If the confidence of the public in the integrity of accountants’ reports is shaken, their value is gone.”

Arthur Andersen in a 1932 Lecture on Business Ethics

Rosemarie is the new controller for a small construction company, Acme builders. She is new on her job and grateful that the CEO, Peter, has allowed her to go on flex‐time to help her take care of her young daughter, who is in day care. Rosemarie is concerned about the collectability of receivables from Fergus Motel, for whom Acme has done extensive work. Rosemarie thinks that the allowance for these receivables must be adjusted. Upon expressing her concern to Peter, she is told that he thinks adjusting for them might put the approval of a much‐needed loan in jeopardy. Rosemarie thinks she should account for them, but it seems clear that when Peter said, “Well … do what you think is right”, he was really saying that he expected her to look out for the company and fudge the figures. Should she be a team player and go along with what Peter obviously wants, but didn’t specifically ask for?

John is a fairly young accountant working at a local CPA firm. John is wrestling with a problem. He is trying to decide whether to cover up a mistake made in not attaching an irrevocable election to a client’s recently submitted tax return. If he does not report the mistake he can relieve a significant portion of the tax burden of an important client. John thinks taxes are unfair anyway, and that his obligation to his client is to look out for the best interest of the client and save him from paying as much tax as possible. John also knows that keeping the client is important for the financial health of the company. Do you think most accountants would cover such a mistake? Would they be justified in covering such a mistake?

Leo is a senior accountant who has been assigned to the audit of a closely held corporation, CHC. Leo discovers that CHC’s income has been materially misstated, probably due to what appears to be a cutoff error, but possibly has been misstated deliberately. Leo takes the information to Adele, the audit manager. The work on the audit has already taken significantly longer than was projected in the budget, and investigating the misstatement would involve too much time. Besides, there are no tax implications due to the mistake, and the managing partner, who is also negotiating a consulting contract with CHC, is pressuring Leo to get the files to him as soon as possible. Adele tells Leo not to mention the adjustment in the working papers, because she sees no tax implications. No harm, no foul. Should Leo follow Adele’s “advice”, or does he have a responsibility beyond that to work for the benefit of the client?¹

Situations such as those portrayed in these scenarios happen every day in the world of accountants. They raise ethical concerns that are typical of those that face accountants, whether they are management accountants, tax accountants, auditors, valuation specialists, or accountants performing any number of other accounting activities.

Such situations occurred long before the now infamous Enron bankruptcy case, in which the auditors and consultants from the accounting firm of Arthur Andersen came under criticism for not appropriately carrying out their responsibilities as accountants. In one instance Arthur Andersen, functioning in the role of outside auditor, failed to detect and/or disclose financial transactions wherein Enron shifted assets to a special purpose entity, which allowed the value of the company to look to be worth significantly more than it was. While defenders of Arthur Andersen declared such activity was within the law and generally accepted accounting principles, critics claimed that accountants are obliged to do more.

We have seen the outcome of the Enron/Andersen case with the demise of both Enron and Andersen and passage of Sarbanes–Oxley and the institution of the Public Company Accounting Oversight Board, but it is important to remember that the Enron/Andersen case did not present new ethical difficulties. It simply brought to light ethical questions that had been simmering for well over a quarter of a century, and unfortunately continue to simmer. Enron/Andersen, because it involved billions of dollars and affected so many people’s lives, brought to light in a dramatic fashion the ethical difficulties accountants face. The Enron/Andersen case, and each of the scenarios above raise the ethical questions: What is the appropriate behavior for accountants? What are accountants supposed to do? What are their responsibilities?

The scenarios, ironically, raise another important point. If you look at the citation, you will see that the scenarios were developed for a business ethics program sponsored by none other than the Arthur Andersen firm. It was a project that brought together leading thinkers of the business ethics community to develop teaching tools to be used in college courses on business ethics. The company was dedicated from its inception to doing the right thing. Arthur Andersen had the reputation from his earliest days in Chicago for being a person of impeccable integrity.

What went wrong with his company is a story written many times from many perspectives. From our perspective there are two main reasons. One is on the individual level. Accountants, at least the Houston offices of Andersen, did not do what they were supposed to do. They made the common mistake of many auditors who think their main obligation is to please the client who hires them. Rather, as we will try to show, accounting has a public purpose. It needs to serve the public good first. We will discuss this at length in the book. The second problem is that the company gave in to the systemic temptations that regularly beset the accounting firms, particularly the large firms. Firms, or the human beings who run them, are susceptible to incentives. We get what we reward. As an auditor, Arthur Andersen had a clear mission, to attest that the financial statements they were auditing reflected what was really going on in the company. However, that mission was shunted aside in the name of fees.

A venerable firm like Andersen, at one time, prided itself in its role as auditor. As an auditing firm it filled an important public function. However, as the large accounting firms grew, they forgot their main function and began to expand. What was the purpose of their expansion? To do consulting. Why? To bring in more profits. There was little reflection on how this consulting impacted on the primary function and responsibility of the auditing firm. There was little speculation about how reliance on consulting fees might impact auditing. It is clear what the responsibilities of an auditor are. However, if consulting brings more profit than auditing, human nature being what it is, the pressure will be there to do those things which enhance our income stream by doing more consulting. If we maintain our consulting work by pleasing our customer with soft auditing, so be it. Individuals and systems are much alike. They both give in to temptations. Hence any serious treatise on ethics needs to look at the pressures put on individual accountants and their firms by the systems in place, and the rewards of the system to determine whether they are aligned with the purposes of the system. These are the major concerns we will try to address in this book on accounting ethics.

Ethics is an overarching human concern that covers all areas of life. In this book we will examine how it is applicable and relevant to this one corner of human activity, accounting. Accounting as a human activity has an ethical dimension, for ethics is involved in all human activity. Human activity is precisely the kind of thing for which one is held responsible; it is activity which is done deliberately which one can control. It is also activity that helps or harms either oneself or others, or that is deemed to be either just or unjust, right or wrong. But to understand fully the ethical dimensions of accounting we will need to examine where and how the activity of accounting fits into the larger scheme of human activities.

We will examine in what way accounting is both an essential practice and a vital profession in the economically developed world of today. It is an essential practice because the current economic system could not exist without it. Business and the market, as we know it, would grind to a halt if there were no way to account for the existence and disposition of the wealth and goods of the world. For financial markets to function efficiently it is necessary to have transactions based on accurate portraits of the financial worth of any entity being traded. Those portraits are painted by accountants. Power relationships, property rights, ownership claims, valuations, receivables, and debts are all mental social constructs that define who owns what and owes what to whom. All of these constructs are identified and tracked by accountants and bookkeepers.

Because of this essential role in tracking the indeterminately large nexus of complicated financial relationships in the economic world of today accounting developed into a service profession. We will examine the nature of the accounting profession from the perspective of the general ethical responsibilities that accrue to professionals, as well as from the perspective of the specific responsibilities that arise from being a professional accountant.

To cover all the areas and activities engaged in by accountants that have an ethical dimension would require an inordinately large book. This book will concentrate on what we see as major areas of concern for the ethics of accounting.

Determining, examining, and evaluating the purposes of activities or practices is one of the major tasks of ethics. This approach to ethics is a functional one and involves an evaluation of a function or purpose. For example, if we take a functional approach to a knife we see that a knife has a basic purpose or function – to cut. It is considered a good knife, with respect to its basic function, if it cuts well, and if it is a dull knife which does not cut sharply, it is not a very good knife. But we can also analyze whether the function itself is a worthwhile activity. Whether cutting is worthwhile depends on what is being cut and why, that is, the purpose for which the activity is carried on.

Every activity is either done for its own sake, in which case it is called intrinsically worthwhile, or it is done for the sake of something else, in which case it is instrumentally worthwhile. Cutting is an instrumental activity for the sake of something else, and it is judged as worthwhile or not depending on the purpose for which it is done. A good knife can be used to cut up food, or it can be used to kill human beings.

Accounting, being a practice and an activity, is done for some purpose. Thus, we can determine whether an accountant is acting well if he or she is fulfilling their purpose: to render accurate portraits of a financial entity. But we can ask the larger question: Why is this activity of creating financial portraits being carried out? What is this practice to accomplish? So accounting as an instrumental activity can also be judged on the basis of the purpose for which it is used. It is important in this context to remember that the clever accountant can hide assets as well as disclose them.

Providing accurate financial pictures of business activities, which is the primary activity of an accountant, is an instrumental activity because it provides a necessary service for those who need that information to engage in financial decision making. While instrumental activities can be viewed as noble activities when they provide great benefits to human beings, they can also be instrumental in bringing about great harm. Accounting and the skills of the accountant can be utilized to do great harm to society if the purposes for which the information is used are harmful or illegal. For example, an accountant for organized crime, or an accountant for the Nazis are providing a useful service for their clients, but their clients corrupt that service by putting it to use for evil purposes or ends. But accounting is not simply limited to business activities. The Congressional Budget Office utilizes accounting principles to determine the costs of pending legislation. The members of congress need accurate pictures of true costs.

Hence we judge the purpose of accounting, which is to provide information of economic affairs, as a laudable purpose. Having done that, though, we need to judge the skilled accountant from the perspective of the use to which his or her accounting skills are put. If it is a noble purpose, to keep a worthwhile business or social entity functioning well it will be lauded. If it is a malicious purpose, to cheat the public out of legitimate tax burdens it will be condemned.

With those goals in mind the book will start, in Chapter 1, by briefly examining the history, nature, and purpose of accounting. Accounting is the invention of human beings and, consequently, the result of human conventions. That being the case, it will be helpful to examine the history of how accounting came to be. Financial activities are necessary for survival in our present world, and because accounting helps facilitate these activities, it is usually a beneficial activity. Still, accounting can be misused to benefit some at the expense of others, to deceive and to defraud others. At such times the accounting might be done well, but the practice and skills of the accountant are denigrated by their unethical use.

After examining the nature of accounting, we will turn our attention to the question: What is ethics? We will examine current ethical theories to show how they can be applied to accounting today. In that discussion we will examine both the ethics of purpose as well as the ethics of relationships. We devote Chapters 2 and 3 to a discussion of this question, detailing not only what we have alluded to above as the ethics of purpose, but also to another aspect of ethics, the ethics of relationships. Ethics is about pursuing the good but it is also about fidelity to ethically acceptable relationships.

A crucial relationship is that of a professional toward his or her clients. Since accounting is a skill demanding expertise, and since accountants have clients who depend on that expertise, accounting can be included among the professions. We will try to show in Chapter 4 why the fact that accounting is a profession invests accounting with an ethical dimension. We will look at the characteristics of professionalism and the notion of agency that is involved in any profession. We will show that being a professional puts obligations upon the accountant to look out for the best interests of various constituencies, from the client to the company to the general public.

Accountants, as professionals, have developed various codes of ethics which stipulate the rules accountants themselves lay down if one is to be an accepted member of a profession. We will examine in Chapters 5 and 6 the American Institute of Certified Public Accountants (AICPA) code of ethics since it is the most extensive code and probably representative of most other codes. We will attempt to show the ethics and ethical standards that code puts forward.

After those considerations we will examine specific ethical issues involved in what seem to be the three major functions of the accountant today.