The Ethics of Accounting Fraud Case Study

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Ethics

There are basically two choices that Chris has. The first is that Chris can increase the allowance for bad debts to account for the possibility that Ender will not be able to pay its obligations. The second choice is that Chris can choose not to make any adjustments for this possibility. The receivable is material, so there are going to be meaningful consequences to the construction company if Ender is unable to pay this debt. Chris has an obligation to ensure that the financial statements for the construction company accurately reflect its financial condition. However, there is the mitigating factor that Chris does not actually have factual evidence of Ender's financial condition, just hearsay ("word on the street").

There are a number of different stakeholders here. The first is Chris; the second is Laurent. They are stakeholders on a person al level, having discussed this situation. The construction company is the biggest stakeholder, however. All internal elements of the construction company are stakeholders in their own right -- the employees, the owners, and the managers. Furthermore, the suppliers and those with whom the construction company does business are also stakeholders. The company is not publicly-traded, so regulators are not stakeholders, but if the allowance for bad debts affects the taxes payable then the IRS would be a stakeholder. Ender is a tangential stakeholder -- the move that Chris makes with respect to his company's accounting will not necessarily even be known by Ender, and will not have any effect on Ender's ultimate ability to pay. The stakeholder table looks as follows:

Stakeholder

Increase Allowance

Do not Increase Allowance

Chris

Lauren

Construction co.

Construction co. owners

Employees of Cons. Co.

Suppliers

Auditor

IRS

Ender

Neutral

Neutral

The Bank

Section II. This issue can be analyzed in terms of different ethical perspectives. Before conducting such analysis, it is worth pointing out that this is not an ethical dilemma -- it is illegal to fail to adjust the allowance if there is good reason to do so. This is as per FASB Topic 310, which states the following, under paragraph 450-20-50-3:

"Disclosure of the contingency shall be made if there is at least a reasonable possibility that a loss or an additional loss may have been incurred and either of the following conditions exists," one being "An exposure to loss exists in excess of the amount accrued pursuant to the provisions of paragraph 450-20-30-1" (FASB Topic 310). The description of the scenario in the case, as a material receivable, where the creditor's situation is widely known and accepted to be tenuous and the likelihood to pay minimal is clearly understood by key decision makers at the construction company. Thus, Chris is faced with a decision of whether to break the law, or not.

This does not meet the criteria for an ethical dilemma. The accounting profession, and our society in general, is governed by laws, and those laws in this case are crystal clear. To violate those laws is a clear moral failing. There is no corresponding moral failing for obeying those laws -- our society simply does not accept utilitarian principles as reasonable excuses for breaking laws. Even if it did, the case that following GAAP would be a moral failing is thin, and hypothetical, and so far into the future that this is simply not a binary choice -- Chris is not condemned to failure if he chooses to follow GAAP. As Chris is not in a situation where he must choose between two courses of action that both require moral failing, he is not in an ethical dilemma by definition (McConnell, 2014).

The following analysis is therefore theoretical only. From a utilitarian perspective, the outcome is actually entirely dependent on whether or not the omission was caught. Should Chris adjust the allowance and not be caught, the theoretical benefits (if Lauren's feeble argument is taken at face value) would be significant, and spread among many stakeholders, including all of the construction company's employees and suppliers. However, the reality is that the odds of this deception going unnoticed are slim, and any positive gains are contingent on Chris beating the odds and having this deception go undetected.

From the utilitarian perspective wherein the greatest good for the greatest number is the determining criterion, the outcomes for the different stakeholders can be taken into account. However, this cannot be done at face value -- the relative importance of the stakeholders, and their pluses and minuses, have to be taken into account. Further, the likelihood of the outcome being positive or negative also needs to be factored in to the calculus, and that is where this ceases to be a dilemma at all.

If it is true that Ender is going to go out of business, then as soon as that happens the construction company is going to have to undertake a full writedown of the receivable.

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Thus, the same negative outcomes with respect to the loan will occur anyway. Further, if Ender goes go out of business by the end of the year, the construction company will still be unable to secure the loan, since that will be known to the lender. Moreover, it will become immediately apparent that the adjustment should have been made, and was not. The odds of an auditor, the lender, and other significant stakeholders figuring out that Chris cooked the books are significantly high that Chris can assume the outcome here will be the worst case scenario. Utilitarian calculus only works when the odds of getting away with the crime are good, and in this case they are not. The odds are highly likely that Chris cannot extend the allowance for that debt without this being discovered, especially as there is an established pattern for how much allowance is normally given to Ender. Again, this is another reason why no moral dilemma exists here -- there is no upside to breaking the law.

Profit maximization, a viewpoint rooted in Friedman's worldview, holds that Chris has a duty to protect shareholder wealth. The problem here is that the likelihood of deception being detected are high. The consequences of detection are steep, and would be far more damaging to the company than the consequences of adjusting the allowance to reflect Ender's current credit situation. If Chris wants to maximize the value of the firm, he needs to follow GAAP and leave it to Lauren to do her job and get that credit regardless. Companies that commit accounting fraud and are caught tend to have a much higher failure rate than those that do not commit accounting fraud. And this is taking Friedman's view at face value -- in truth many strong arguments have been made against his position, including Mackey's argument that other stakeholders are critical to the success of the business, and their interests need to be met as well as those of the investors, who would without the other stakeholders have nothing but a shell in which to invest (Mackey, 2005).

Universalism is an ethical view rooted in Kant's categorical imperative. In this situation, the categorical imperative is determined by law, because the law is one universal standard by which everybody is expected to operate. A case could be made that not all laws are aligned with the universal imperative by which society exists due to certain flaws in the legal process, but the laws regarding disclosure of bad debt risk are rooted in traditional accounting practice, and the need for companies to behave in a consistent manner for the betterment of the economy as a whole. Investors can rely on accounting information when GAAP is followed, which encourages higher rates of investment. Thus, not following GAAP not only is illegal, but it undermines the roots of the American capital markets system.

Section III. Insomuch as there is a decision to make, Chris has to adjust the allowance for bad debts to reflect the likelihood that the material receivable from Ender will not be received. This is as per the relevant code of Generally Accepted Accounting Principles, first and foremost. Because of that, it is also aligned with universalist principles. Further, both the utilitarian and profit maximization perspectives come to the same conclusion -- it is almost impossible that this deception will go unnoticed, because the company is likely to go bankrupt anyway, at which time a writedown will occur. This also means that the hypothetical positive outcomes from the accounting fraud will not end up accruing anyway. Where there is no upside, and only downside, there is no moral dilemma. Chris has no downside to obeying the law here. The company simply needs to find another solution to its desire to secure a loan next year -- and it will have to do this no matter what Chris decides if Ender is going out of business before the end of the year.

Ultimately, Chris only has one choice here, supported by all rational, legal and ethical analysis. He is not faced with a choice to….....

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