Organizational Ethics and Corporate GovernanceChapter 3Cop.docx

Organizational Ethics and Corporate Governance
Chapter 3
Copyright ©2020 McGraw-Hill Education. All rights reserved.
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Organizational Ethics, Ethical Culture, and Ethical Climate
Organizational Ethics
Generally accepted principles and standards that guide behavior
in organizational contexts.
Ethical Culture
Explicit statement of values, beliefs and customs from top
management
Organizational ethical climate
Moral atmosphere and level of ethics practiced within a
company
Determined by leaders
Shared values, beliefs, goals, and problem-solving
Focuses on issues of right and wrong
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Establishing an Ethical Culture
Corporate culture is the shared beliefs of top managers in a
company about how they should manage themselves and other
employees, and how they should conduct business.
Tone at the top refers to the ethical environment that is created
in the workplace by the organization’s leadership.
Corporate culture starts with an explicit statement of values,
beliefs, and customs from top management.
A code of ethics serves as a guide to support ethical decision
making.
It clarifies an organization’s mission, values, and principles,
linking them with standards of professional conduct.
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Framework for Understanding Ethical Decision Making in
Business
Ethical Issue Intensity
Importance of the issue to the individual, work group and/or
organization (intensity) based on values, beliefs and norms
involved and pressures in the workplace.
Individual Factors
Values of individuals
Organizational and social forces shape behavioral intentions and
decision making
Organizational Factors
Organization’s values have a greater influence than a person’s

own values.
Opportunity
Conditions that limit or permit ethical or unethical behavior
Business Ethics Intentions, Behavior, and Evaluations
Organizational ethical culture is shaped by effective leadership
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Ethical Leadership
Leaders of Good Character
Possess integrity, courage, and compassion
Careful and prudent
Decisions and actions inspire employees to act in an enhancing
way
Virtues
Courage, temperance, wisdom, justice, optimism, integrity,
humility, reverence and compassion
Role Models
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Key Markers of Highly Ethical Organizations
Humility
Zero tolerance for individual and collective destructive
behaviors
Justice
Integrity
Trust
A focus on process
Structural reinforcement
Social responsibility
Values-driven organization that encourages openness,
transparency, and provides supportive environment to voice
values without fear of retribution or retaliation
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Organizational Influence on Ethical Decision Making
The Jones-Hiltebeitel model looks at the role of one’s personal
code of conduct in ethical behavior within an organization
Moral intensity
When one’s personal code is insufficient to make the necessary
moral decision, the individual will look at professional and
organizational influences to resolve the conflict

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Ethical Dissonance Model
Interaction between the individual and the organization, based
upon person-organization ethical fit at various stages of the
contractual relationship in each potential ethical fit scenario
Four potential fit options:
High-High (high organization & high individual ethics)
Low-Low (low organization & low individual ethics)
High-Low (high organization & low individual ethics)
Low-High (low organization & high individual ethics)
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Seven Signs of Ethical Collapse
“Occurs when any organization has drifted from the basic
principles of right and wrong” Marianne Jennings
Pressure to maintain numbers
Fear and silence
Young ‘uns and bigger than life CEO
Weak board of directors
Conflicts of interests overlooked or unaddressed
Innovation like no other company
Goodness in some areas atones for evil in others

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Pressure to Maintain Numbers and Fear of Reprisals
Ethical collapse occurs when there is an unreasonable and
unrealistic obsession with meeting quantitative goals
“financial results at all costs”
Employees are reluctant to raise issues of ethical concern
because they may be ignored, treated badly, transferred or
worse
“kill the messenger syndrome”
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Loyalty to the Boss and Weak Board of Directors
Young people selected by the CEO for their position based on
inexperience, possible conflicts of interest, and unlikelihood to
question the boss' decisions
Weak board of directors characterizes virtually all of the
companies with major accounting frauds in the early part of the
2000s
Culture of Conflicts

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Corporate Governance Structures
and Relationships
Corporate governance is shaped by internal and external
mechanisms.
Internal mechanisms help manage, direct, and monitor corporate
activities to create sustainable stakeholder value.
Examples: independent board of directors, the audit committee,
management, internal controls and the internal audit function
External mechanisms are intended to monitor the company’s
activities, affairs, and performance to ensure that the interests
of insiders (management, directors, and officers) are aligned
with the interests of outsiders (shareholders and other
stakeholders).
Examples: the financial markets, state and federal statutes,
court decisions, and shareholder proposals
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Potential Agency Problems

Executive Compensation – compensation packages are tied to
firm performance and stock option plans creating an incentive
to manipulate earnings
Backdating stock options and improper disclosures
Clawbacks allow a recovery of compensation from CEOs and
CFOs of public companies
“Say on pay” provisions provide shareholders a vote regarding
the compensation of CEO and CFOs
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Corporate Social Responsibility Example:
The Ford Pinto Case
Subcompact car
Unsafe gas tanks could burst into flames
Initial ethical legalism defense
Risk/cost benefit analysis
Too costly to replace the fuel tanks
Compliance with law versus ethical behavior – met all safety
requirements
Utilitarian reasoning
Focusing on costs and benefits
Ignores rights of various stakeholders
Ignored cost of potential lawsuits

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Stakeholder Orientation
Business Stakeholders
Investors and shareholders, creditors, employees, customers,
suppliers, government agencies, communities and others
Have a “stake” or a claim in some aspect of a company’s
products, operations, markets, industry and outcome
Stakeholder orientation is the degree to which an organization
understands and addresses stakeholder demands. Consists of:
Generation of data about stakeholder groups and assessment of
the firm’s effects on these groups
Distribution of this information throughout the firms
The responsiveness of the organization as a whole to this
information
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Johnson & Johnson:
A Case of Dr. Jekyll and Mr. Hyde?
J&J’s credo emphasizes primary obligation to those who use
and rely on the safety of its products
Tylenol Poisoning – J&J put customer safety first

J&J has been withdrawing from its “trust” bank in recent years
Illegally promoted the antipsychotic Risperdal
Misleading statements about the recall of Motrin
Included methylene chloride, which is banned by the FDA, in
their baby shampoo
DePuy Orthopaedics sold metal-on-metal hip implants that were
found to shed minute particles into a patient’s bloodstream over
time
Ethicon vaginal mesh did not meet reasonable safety standards
Takes a long time to build a reputation of trust, but not very
long at all to tear it down.
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Trust in Business
Trust means to be reliable and carry through words with deeds.
Trust becomes pervasive only if the organization’s values are
followed and supported by top management.
Trust can be lost, even if once gained in the eyes of the public,
if an organization no longer follows the guiding principles that
helped to create its reputation for trust.
Credo is an aspirational statement that encourages employees to
internalize the values of the company.
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Ethical and Legal Responsibilities
of Officers and Directors
Directors and officers are deemed fiduciaries of the corporation
as their relationship with the corporation and its shareholders is
one of trust and confidence
Duty of Care – act in good faith, exercise the care that an
ordinarily prudent person would exercise in a similar situation
Duty of Loyalty – act in the best interest of corporation; loyalty
can be defined as faithfulness to one’s obligations and duties
Duty of Good Faith – requires an honesty of purpose that leads
to caring for the well-being of the constituents of the fiduciary
Business Judgment Rule – expected to exercise due care and to
use their best judgment in guiding corporate management, but
they are not insurers of business success; honest mistakes and
poor business decisions do not make them liable to the
corporation for resulting damages
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Best Practices of Governance
Independent directors enhance governance accountability
Separation of the duties of CEO and board chair minimizes
conflicts of interest
Separate meetings between the audit committee and external
auditors strengthen control mechanisms

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Ethics in the Workplace
A code of conduct goes beyond what is legal for an organization
and provides normative guidelines for ethical conduct. Support
for ethical behavior from top management is a critical
component of fostering an ethical climate.
Measures that should be taken to establish an ethical culture:
Clear policies on ethical conduct including a code of ethics
Ethics training program that instills a commitment to act
ethically and explains the code provisions
A top level officer (Chief Ethics and Compliance Officer) to
oversee ethics and compliance
Use internal auditors to investigate whether ethics policies are
followed
Strong internal controls to prevent and detect unethical
behaviors
Whistleblowing policies, including reporting outlets
Ethics hot line for anonymous tips
Ethics statement signed by employees
Enforce ethics policies fairly and take immediate action against
violators
Reward ethical behavior and include in performance evaluation
system

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2013 National Business Ethics Survey
Views of Employees from 2011-2013:
Observed misconduct have declined between 2011 and 2013.
Pressure to compromise ethical standards declined but
retaliation against whistleblowers increased; increase in ethics
training programs and the use of ethical conduct in employees
evaluations.
Six most observed types of misconduct: (1)stealing or theft,
(2)falsifying time reports, (3) falsifying expense reports,
(4)falsifying and manipulating financial reporting information,
(5)falsifying invoices, books, and records, and (6) accepting
gifts or kickbacks.
Concern that while misconduct is down overall, a relatively
high percentage of misconduct is committed by managers.
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ACFE 2018 Report to the Nation:
Occupational Fraud
Fraud can be defined as a deliberate misrepresentation to gain
advantage over another party
Typical business loses 5% of annual revenues to fraud
The average loss from fraud was $2.75 million

Frauds lasted a median of 16 months before detection
Occupational fraud is use of one’s position to misappropriate
organization’s resources or assets for personal gain
More likely to be detected by tip, using hotlines, than any other
way
Asset misappropriation schemes most common type of
occupational fraud
Proactive fraud prevention and detection controls are a vital
part in managing the risk of fraud
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ACFE 2018 Report to the Nation:
Occupational Fraud (continued)
Frequency of Anti-Fraud Controls
External audit of financial statements – 80%
Code of conduct – 80%
Internal audit department - 73%
Management certification of financial statements - 72%
External audit of internal controls - 67%
Management review - 66%
Hotlines – 63%
Independent audit committee - 61%

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Behavioral Indicators of Fraud
Living Beyond Means
Financial Difficulties
Unusual Close Association with Vendor/Client
Control Issues, Unwillingness to Share Duties
Wheeler-Dealer Attitudes
Divorce/Family Issues
Instability, Suspiciousness or Defensiveness
Addiction Problems
Complained about Inadequate Pay
Refusal to Take Vacations
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Financial Statement Fraud
Fraud schemes occur because an employee – usually top
management – causes a misstatement or omission of material
information in the organizations’ financial reports.
Methods include:
Revenue Overstatement
Recording gross, rather than net, revenue
Recording of revenues of other companies, acting as a
‘middleman’

Recording sales that never took place
Recording future sales in the current period
Recording sales of products that are out on consignment
Expense Understatement
Recording cost of sales as a non-operating expense
Capitalizing operating costs
Not recording some expense at all
Improper Asset Valuations
Manipulating reserves
Changing the useful lives of assets
Failing to take a write-down when needed
Manipulating estimates of fair market value
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Why does Financial Statement Fraud Occur?
Situational pressure
Perceived opportunity
Rationalization
A culture is created and tone at the top established that presents
the image of a company willing to do whatever it takes to paint
a rosy picture about financial results.
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Liability for False Certifications
SEC’s increased focus on identifying and penalizing
misstatements in public company financials
Analyzing patterns of internal control problems even absent a
restatement of the financials
Quality Services Group Inc. (QSGI) CEO and CFO held
responsible for alleged misrepresentations in public disclosures
about the company’s internal controls environment
Signed Form 10-Ks with management reports on internal
controls that falsely omitted issues
Signed certifications in which they falsely represented that they
had evaluated the management report on internal controls and
disclosed all significant deficiencies to auditors
Transparency with the company’s audit committee and with
external auditors regarding evaluations of the company’s
internal controls and whether it protects the company, its
investors, and its officers
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Miniscribe Fraud
Top management committed the fraud and overrode internal
controls
Company lacked independent members on its Board of Directors
Salaries and bonuses often depended on Miniscribe “making the
numbers”

Inventory hole initially worth $2-4 million, then $15 million
Miniscribe bought bricks to disguise as hard drives and conceal
as inventory worth $4 million
Repeatedly signed management letter stating financial reports
were accurate and truthful
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Has SOX Accomplished its Intended Goal?
Section 302 requires CEO and CFO to certify financial
statements contain no material misstatements
Helps protect the public against fraudulent financial statements
Very few defendants have been charged with false certification,
and fewer still have been convicted
Richard Scrushy, former HealthSouth Corporation CEO
Indicted but found not guilty on false certification
Weston L. Smith, CFO, pleaded guilty in scandal, sentenced to
27 months in prison
CFO of DVI pleaded guilty to mail fraud and false certification,
sentenced to 30 months in prison
SEC increasingly is pursuing claims against CFOs by alleging
that the CFOs subordinates violated securities laws and the CFO
either certified the resulting reports or failed to implement
adequate internal safeguards

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Audit Committee
Independent directors with one having financial expertise
Oversight of financial reporting
Internal audit function
External auditors
CEO and CFO financial statement certification process
Review formal announcements of earnings, significant financial
reporting judgments, internal controls and risk management
procedures, whistleblower and compliance program, external
auditor’s independence and objectivity and effectiveness of
audit process
Seen as the one body that should be able to prevent identified
fraudulent financial reporting
Committee should meet separately with the senior executives,
the internal auditors, and the external auditors
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Internal Auditors
Monitor corporate governance activities and compliance with
organization policies
Review effectiveness of the organization’s code of ethics and
whistle-blower provisions

“Eyes and ears” of audit committee
Assess audit committee effectiveness and compliance with
regulations
Oversee internal controls and risk management processes
Assurance on how effectively the organization assesses and
manages its risk
Assurance on data security and privacy controls
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External Auditors
An obligation to the public interest that underlies their
corporate governance responsibilities
Protect the interests of shareholders
Conduct audits independent of any influence of management or
the company
Communicate effectively with the audit committee: accounting
policies and procedures, estimates by management; quality of
financial reporting; potential violations of laws
Ensures accountability for financial reporting process
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Internal Controls
Prevent and detect errors and fraud
Asset misappropriations
Materially false and misleading financial reports
Inadequate disclosures
Ensure management policies are followed
Ethical systems built into corporate governance
Can be overridden by top management
Do what CEO says, not what he does
Creates cynical attitude
Managers need to “walk the talk” of ethics
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COSO Internal Control – Integrated Framework
Emphasizes roles of BOD, management, internal auditors, and
personnel
Designed to provide reasonable assurance
Effectiveness and efficiency of operations
Reliability of financial reporting
Compliance with laws and regulations
Framework
Control environment: ethics of the organization
Risk assessment
Control activities
Monitoring
Information and communication

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Internal Control Weaknesses
Internal control includes all of the processes and procedures
that management puts in place to help make sure that its assets
are protected and that company activities are conducted in
accordance with the organization’s policies and procedures.
An effective system of internal controls is critical to establish
an ethical corporate culture that should be supported by the tone
at the top.
An internal control system, no matter how well conceived and
operated, can provide only reasonable - not absolute – assurance
to management and the board of directors regarding
achievement of an entity’s objectives.
Management override of internal controls may be a problem.
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Whistleblowing
Employees (former or current) who report suspected violations
to persons or organizations that may be able to effect action

Illegal
Immoral
Illegitimate
Four elements:
The whistleblower
The whistleblowing act or complaint
The party to whom the complaint is made
The organization involved with the complaint
“Organizational Dissidence” – similar to civil disobedience
Whistleblower laws protects employees who provide
information on a fraud against retaliation
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Morality of Whistleblowing
Organizational policies should be designed to encourage moral
autonomy, individual responsibility, and organizational support
for whistleblowers
Moral agency is important for the determination of moral
behavior
Autonomy means to act according to reasons and motives that
are taken as one’s own and not the product of policies, laws,
etc.
If pressure exists in an organization not to report wrongdoing, a
rational, moral person will withstand such pressure, even with
perceived retaliation, because it is a moral requirement to do so

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Morality of Whistleblowing (continued)
Michael Davis considers whistleblowing to be morally required
when it is required at all; a moral obligation to prevent serious
harm to others if it can be done with little cost to the individual
Application of a rule utilitarian perspective could lead to the
conclusion that a categorical imperative exists to do whatever it
takes to stop fraudulent behavior regardless of whether the
action might bring more harm than good to the stakeholders
DeGeorge thinks “corporations have a moral obligation not to
harm.” His criteria for when whistleblowing is morally
permitted includes
Firm’s actions will do serious and considerable harm to others
Whistleblowing is justifiable once the employee reports it to her
supervisor and makes her moral concerns known
Absent any action by the supervisor, the employee should take
the matter all the way up to the board
Documented evidence must exist that would convince a
reasonable and impartial observer that one’s view of the
situation is correct and that serious harm may occur
The employee must reasonably believe that going public will
create the necessary change to protect the public and is worth
the risk to oneself
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Rights and Duties
Whistleblowers hope and believe their speaking out will achieve
correction of what they perceive as the organizational
wrongdoing
“Retaliatory climate” in the organization is the primary barrier
to blowing the whistle on corporate wrongdoing
When organizations establish an ethical culture and anonymous
channels to report wrongdoing, it creates an environment that
supports whistleblowing and whistle-blowers while controlling
for possible retaliation
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Menendez v Halliburton, Inc.
Menendez was the Director of Technical Accounting Research
and Training
Only months before that Halliburton had settled with the SEC
after a two-year accounting probe
Menendez realized the company was violating very basic
accounting revenue recognition rules
Accountants were counting the full value of the equipment right
away as revenue, even before it had assembled the equipment,
customer could walk away until delivery, and Halliburton was
liable for loss on damaged equipment
Menendez tried to get Halliburton to change accounting method,
but no action was taken

He then spoke to the SEC and was told to go to the audit
committee
Halliburton’s general counsel circulated Menendez’s complaints
to the CFO, KPMG, other top executives and accounting
department
He was stripped of his responsibilities and became a pariah at
the firm
Appeals court panel ruled that Menendez had been retaliated
against for blowing the whistle
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Compliance Function
Organization’s ethics officer
Ensures that the organization is in compliance with the laws and
regulations, including SEC securities laws, SOX, and Dodd
Frank
May report to the audit committee, …

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