Organizational Ethics and Corporate GovernanceChapter 03© 20.docx

Organizational Ethics and Corporate Governance
Chapter 03
© 2023 McGraw Hill, LLC. All rights reserved. Authorized only
for instructor use in the classroom. No reproduction or further
distribution permitted without the prior written consent of
McGraw Hill, LLC.
Because learning changes everything.®
Learning Objectives
L O 3-1: Describe the causes of fraud, detection methods, and
preventative controls.
L O 3-2: Describe the signs that an organization has collapsed
ethically.
L O 3-3: Discuss compliance, integrity, and employee views
about ethics in the workplace.
L O 3-4: Describe the scope and role of corporate governance
systems in the ethical decision-making process.
L O 3-5: Explain the models of corporate governance and
ethical expectations of organizations.
L O 3-6: Explain how the provisions of the Sarbanes-Oxley Act
relate to corporate governance, including relationships with key
parties.
L O 3-7: Discuss whistleblowing procedures under Dodd-Frank
and concerns about the program.
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Fraud in Organizations
Fraud can be defined as a deliberate misrepresentation to gain
an advantage over another party. Fraud comes in many different
forms, including fraud in financial statements, the
misappropriation of assets (theft) and subsequent cover-up, and
disclosure fraud.
Fraud is not the same as an error, which can occur innocently.
Fraud is a purposeful act to mislead others.
A common element of fraud is it leads to (material)
misrepresentation of the financial statements.
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How Fraud is Detected
According to the ACFE study of Occupational Fraud, the most
common method of detection was a “tip,” (43%).
In organizations with hotlines, 49% come from a tip but
declines to 31% percent in organizations with no hotline.
Internal audit was next with 15% followed by management
review (12%).
The results indicate the need for strong internal controls and an
effective audit committee.
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Fraud Detection MethodsDetection MethodPercentage
ReportedMedian LossTip43%$145,000Internal
Audit15%$100,000Management
Review12%$100,000Other 6%N/ABy
Accident 5%$200,000Account
Reconciliation4%$81,000Document
Examination3%$101,000External Audit4%$150,000
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Red Flag Warnings of Fraud
Individual behavioral traits/warning signs include living beyond
one’s means (42%) and financial difficulties (26%).
The question is how can the anti-fraud controls identify these
behavioral indicators of fraud?
Red flags might show up through internal and external
relationships.
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Frequency of Anti-Fraud Controls 1
Internal controls do not guarantee protection against fraud,
however
They can help to both mitigate losses and deter some potential
fraudsters.
With 43 percent of frauds being detected by tips, hotlines
should play an essential role in organizations’ anti-fraud
programs.
However, only 64% had a hotline mechanism in place and 13%
provided rewards for whistleblowers.
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Frequency of Anti-Fraud Controls 2Anti-Fraud
ControlPercentage ReportedExternal Audit of Financial
Statements83%Code of Conduct81%Internal Audit
Department79%Management Certification of Financial
Statements73%External Audit of Internal Controls over
Financial Reporting68%Management
Review65%Hotline64%Independent Audit Committee62%
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Behavioral Indicators of FraudBehavioral Indicators of
FraudPercentage ReportedLiving Beyond Means42%Financial
Difficulties26%Unusually Close Association with
Vendor/Customer19%Control Issues, Unwillingness to Share
Duties15%No Behavioral Red Flags15%"Wheeler-dealer"
Attitude 13%Irritability, Suspiciousness, or
Defensiveness13%Divorce/Family Problems12%
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Financial Statement Fraud
A variety of factors discourage the reporting of fraud:
Poor tone at the top.
Dominating and intimidating personalities.
Mistrust.
Excessive team loyalty.
Management does not want to hear about problems.
A lack of sound policies and procedures.
Perception that wrongdoing will not be addressed if misconduct

is reported.
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Why Employees Don’t Come Forward
Fear of the unknown.
Fear that the report will not be handled anonymously or
confidentially.
Fear that the reporter’s identity will be revealed to others in the
organization.
Concern that the person perpetrating the misconduct will not be
held responsible.
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Possible Consequences of Reporting Fraud
Retaliation by co-workers.
Termination.
Future reputation.
Impact on others.
Results of investigation determine that the misconduct is
unsubstantiated.
Emotional cost of whistleblowing.
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How Financial Statement Fraud Occurs
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
May prompt an otherwise honest person to commit fraud.
Typically occurs as a result of immediate pressure within the
internal or external environment.
Perceived opportunity
The opportunity to commit fraud and conceal it must exist.
Rationalization
People who commit financial statement fraud are able to
rationalize the act.
Being able to justify the act makes it possible.
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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.
Bigger than life C E O.
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.”
Companies manipulate earnings to meet financial analyst
expectations.
Those who report wrongdoing are ignored.
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Fear of Reprisals
A culture of fear and silence can easily mask ethical problems.
Employees may be reluctant to raise issues of ethical concern
because they may be ignored, treated badly, transferred, or
worse.
The whistleblowing process in many organizations does not
work because there is no hotline to report anonymously.
The whistleblowing process does not work because allegations
are not taken seriously.
A “kill the messenger syndrome” exists when the organization
does not want to hear about wrongdoings, so it responds

negatively to the messenger.
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Loyalty to the Boss and Weak Board of Directors
Young people selected by the C E O for their position based on
inexperience, possible conflicts of interest, and unlikelihood to
question the boss’s decisions.
Weak board of directors exists because of conflicts of interest
arise from relationships between board members and the
company/top management.
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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 hotline 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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K P M G Integrity Survey
Employees asked what they would do if they observed a
violation of their organization’s standards of conduct:
78% would notify their supervisor or another manager.
54% would try resolving the matter directly.
53% would call the ethics or compliance hotline.
26% would notify someone outside the organization.
23% would look the other way or do nothing.
75% would inform their supervisor.
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Employee Perception About Ethics in the Workplace
When organizations prioritize integrity, employees are:
Less likely to feel pressure to violate ethics standards;
Less likely to observe misconduct;
More likely to report misconduct they observe; and,
Less likely to experience retaliation for reporting.
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Using Social Media to Criticize the Employer
Employees sometimes feel inclined to post negative comments

about their employer outline.
When those comments are solely made by the individual with no
input from others, the N L R B treats it as a “personal gripe”
and it’s not protected speech.
When others comment on the posting, it is protected because it
is deemed to be a “concerted effort,” — that is, more
representative of the group, not one’s individual feelings.
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Ethical and Legal Responsibilities of Officers and Directors
Directors and officers are 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.
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Role of Corporate Governance Systems
Maximize shareholder wealth
Problems of agency costs.
Executive compensation packages/stock options.
Represent all stakeholders
Investors, creditors, employees and other interests considered.
Stewardship Function
Fiduciary duty of managers.
More consistent with stakeholder views.
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Corporate Governance Oversight and Regulation
Independent directors
Executive versus nonexecutive directors.
Audit committee responsibilities.
Oversee financial reporting
Work with internal and external auditors.
Monitor internal controls.
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Key Audit Committee Responsibilities
Meet at least annually with the independent auditor and review
the audit report describing independent auditor’s internal
quality control procedures.
Discuss all relationships between the independent auditor and
the company to enable assessment of the auditor’s
independence.
Discuss earnings press releases and financial information and
earnings guidance given to analysts and rating agencies.
Discuss policies with respect to risk assessment and risk
management.
Meet separately, from time to time, with management, with
internal auditors, and with independent auditors.
Review with the independent auditor any audit problems or
difficulties and management’s response to such issues.
Report regularly to the board of directors.
Evaluate work of the audit committee annually.
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Corporate Social Responsibilities
Refers to the ethical expectations that society has for business.
Ethical responsibilities are those things that we ought to, or
should do, even if we prefer not to.
Corporations have an ethical responsibility to prevent harm.
Sexual harassment.
Other forms of discrimination.
Workplace safety.
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Sustainability
Forerunner of conscious capitalism.
Sustainability describes the ability to maintain various systems
and processes.
Environment.
Social responsibilities.
Social equality.
Economic.
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Triple Bottom Line
The three “Ps”
People.
Planet.
Profit.
Describing the scope of reporting in three broad areas affecting
society:
Economic including financial reporting.
Ecological including the environment.

Social including social responsibility.
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Economic Model of C S R
Businesses’ sole social responsibility is to fulfill the economic
functions they were designed to serve.
Managers must work to further the owners’ interests.
Dominant model of C S R: “managerial capitalism.”
Places shareholders at the center of the corporation.
Ethical responsibility is to serve those shareholders.
Argued for by Milton Friedman as the one and only social
responsibility of business.
Increase profits by pursuing profits without deception while
playing within the rules.
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Stakeholder Model of C S R
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 to this information.
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Example of Good C S R?: The Case of the Ford Pinto
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.
Focus on costs and benefits.
Ignores rights of various stakeholders.
Ignores cost of potential lawsuits.
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Corporate Governance Structures and Relationships: Sarbanes
Oxley
Section 301
Independent audit committee.
Receive whistleblower complaints.
Section 302
Certification of financial statements by C E O & C F O.
Section 404
External auditor report on management assessment of
effectiveness of internal controls.
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Sarbanes-Oxley Act

Section 406
Code of ethics for financial officers.
Section 806
Prohibits retaliation against whisteblowers.
Section 906
Written statement by the C E O and C F O about compliance
with S E C reporting requirements.
Financial statements present, in all material respects, the
financial condition and results of operations.
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Liability for False Certifications
S E C’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. (Q S G I) C E O and C F O 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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Internal Control Relationships
With internal auditors.
Should have direct and unrestricted access to the audit
committee.
Audit committee.
Financial statement certification process.
Establish disclosure controls.
Responsible for channeling employees to submit confidential
concerns over accounting and auditing matters.
Whistleblower hotline.
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Audit Committee
Independent directors with one having financial expertise.
Oversight of financial reporting.
Internal audit function.
External auditors.
C E O and C F O 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.
Ensure 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 C E O says, not what he does.
Creates cynical attitude.
Managers need to “walk the talk” of ethics.
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C O S O Internal Control – Integrated Framework
Emphasizes roles of B O D, 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 Whisteblowing 1
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 Whisteblowing 2
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 include:
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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Exhibit 3.12 Whisteblower Reporting Mechanisms
MechanismPercentage Reported Telephone
Hotline33%Email33%Web-based/online form32%Mailed
letter/form12%Other9%Fax1%
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Exhibit 3.13 To Whom Did Whisteblowers Initially Report?
Reporting methodPercentage Reported Direct
supervisor28%Other15%Fraud investigation team14%Internal
audit12%Executive11%Coworker10%Law Enforcement or
regulator7%Owner7%Board or audit committee6%Human
resources6%In-house counsel4%External audit1%
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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 S E C
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 S E C and was told to go to the audit
committee.
Halliburton’s general counsel circulated Menendez’s complaints
to the C F O, K P M G, 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 S E C securities laws, S O X, and Dodd
Frank.
May report to the audit committee, C E O, or general counsel.
Official member of the c-suite.
Addresses existing requirements and anticipates regulatory

changes and their likely impact.
Ethics and Compliance Officer Association (E C O A).
Ethics officer plays a critical role in helping create a positive
ethical tone in organizations.
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Dodd-Frank Wall Street Reform and Consumer Protection Act
2010 passage of Dodd-Frank established benefits for
whistleblowers who aid in recovery of $1M or more and they
can receive 10-30% of the recovery.
Defines a whistleblower as any individual who voluntarily
provides information to the S E C relating to a violation of
federal securities laws, is ongoing or is about to occur.
Voluntarily means the whistleblower has not provided the
information previously to the government, a self-regulatory
organization, or the P C A O B.
Concern: Will whistleblowers go external rather than internal
with the information in order to receive an award (“bounty
hunter”)?
Employees have a loyalty obligation to their employers, but
loyalty should not be used to mask one’s ethical obligation to
maintain integrity and protect the public interest.
Whistleblowing in conformity with Dodd-Frank rules sets aside
confidentiality requirement.
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Internal Accountants’ Eligibility
Internal accountants, including compliance and internal
auditors, are excluded from receiving whistleblower awards
under Dodd-Frank because of pre-existing legal duty and job

responsibilities to report suspicion of illegal acts and fraud to
management.
Under the following circumstances, internal accountants are
eligible to become Dodd-Frank whistleblowers:
Disclosure to the S E C is needed to prevent “substantial injury”
to the financial interest of an entity or its investors.
The whistleblower “reasonably believes” the entity is impeding
investigation of the misconduct (for example, destroying
evidence or improperly influencing witnesses).
The whistleblower has first reported the violation internally and
at least 120 days have passed with no action.
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External Auditor Eligibility
Whistleblower rules allow the auditor or an employee associated
with the auditor to make a whistleblower submission alleging
that the firm failed to assess, investigate or report wrongdoing
in accordance with Section 10A, or that the firm failed to follow
other professional standards.
Concerns about permitting C P As to obtain monetary rewards
for blowing the whistle on their own firms’ performance of
services for clients create significant problems including:
Undermining the ethical obligations of CPAs not to divulge
confidential client information.
Harming the quality of external audits because client
management might restrict access to client information for fear
the financial incentive for whistleblowing could lead to report
client-specific information to the S E C.
Overriding the firms’ internal reporting mechanisms for audit-
related disagreements.
Incentivizing an individual to bypass existing programs to
report disagreements including hotlines.
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Integrity Considerations
It is the integrity standard that establishes the basis for moral
action of auditors and avoids subordinating judgment.
Reporting procedures for accountants and auditors under the A I
C P A Code (Exhibit 3.11).
The C P A should seek legal advice when difference of opinion
exists on how best to handle disagreements with the client and
the firm refuses to make the required adjustments.
The auditor should consider whether the relationship with the
organization should be terminated including possibly resigning
one’s position.
Resignation from the audit firm does not negate the auditor’s
disclosure responsibilities to the S E C.
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Accountants’ Obligations for Whisteblowing
Dodd-Frank contains provisions to encourage accountants and
auditors to report corporate wrongdoing, and Section 10A of the
S E C 19 34 Act requires reporting of fraud.
Whistleblowing in accounting is a duty when it is motivated by
a desire to protect the public, confidentiality obligation not
withstanding.
Process in deciding to report fraud.
Whether the violations have a material effect on the financial
statements.
Has management or B O D taken remedial action?
If not, auditor must report to B O D. The board has one business
to inform the S E C and provide copy to external auditor.
If auditing firm does not receive a copy within one business

day.
Provide a copy of its own report to the S E C within one
business day, or
Resign from the engagement and provide copy of report to the S
E C within one business day of resigning.
The process must be handled through the client’s internal
compliance system before external auditors turn to
whistleblowing.
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Whisteblowing Payouts
June 4, 2020, $50 million whistleblower award.
Largest ever rewarded to one whistleblower.
Since its inception in 2011, S E C’s whistleblower program has
paid more than $175 million to whistleblowers.
Whistleblowing program is the right thing to do to protect the
public interest, but concerns are:
A self-interested and opportunistic person may be induced to
reveal company information to the S E C, with inadequate
safeguards as to the quality of information provided.
Permitting compliance officers to become whistleblowers solely
on the passage of time rather than case-specific considerations
can erode corporate culture and trust in compliance officials
who may subvert the objectives of preventing, detecting, and
remediating corporate misconduct on an enterprise-wide basis.
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Whisteblowers and Confidential Information
Erhart v. BofI Holdings.
Clarifies that employer confidentiality agreements do not

supersede federal whistleblower rights.
Signals that retaliatory lawsuits against whistleblowers are
unlikely to succeed.
Provides guidance to corporate whistleblowers concerning the
use of company documents to blow the whistle.
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Conclusion: Creating an Ethical Culture
Creating an ethical culture is a necessary but insufficient
condition to ensure that ethical behavior occurs.
Individuals within the organization may attempt to subvert the
systems and pressure others to look the other way or go along
with wrongdoing under the guise of being a team player or
accepting a one-time fix to a perceived problem.
In these situations, outlets should exist for employees to voice
their values when they believe unethical or fraudulent behavior
has occurred.
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Cognitive Processes and Ethical Decision Making in Accounting
Chapter 02
© 2023 McGraw Hill, LLC. All rights reserved. Authorized only
for instructor use in the classroom. No reproduction or further
distribution permitted without the prior written consent of
McGraw Hill, LLC.

Because learning changes everything.®
Learning Objectives
L O 2-1: Analyze the thought processes involved in, and the
impact cognitive biases have on, making decisions and taking
ethical action.
L O 2-2: Describe Kohlberg’s stages of moral development.
L O 2-3: Explain Rest’s Model and how its components
influence ethical decision making.
L O 2-4: Describe the link between organizational culture,
ethical climate, ethical leadership, and ethical decision making.
L O 2-5: Distinguish between Equity, Diversity, and Inclusion.
L O 2-6: Apply both the Integrated Ethical Decision-Making
Model and the Giving Voices to Values Methodology to a case
study.
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Chapter Organization
Access the text alternative for slide images.
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Learning Objective 1
Analyze the thought processes involved in, and the impact

cognitive biases have on, making decisions and taking ethical
action.
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Behavioral Ethics
Behavioral ethics emphasizes how individuals actually make
decisions and the impact our cognitive biases have on those
decisions.
Kahneman’s suggests two distinct modes of decision making:
System 1 thinking is an intuitive system of processing
information.
Fast, automatic, effortless, and emotional.
System 2 thinking is a reasoned decision process.
Slower, conscious, effortful, and explicitly.
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Cognitive Biases
Understanding unconscious biases that people may have is an
important first step to preventing unethical behavior.
Where these bias’s come from.
Types of Biases.
Incrementalism.
Situational Factors.
Cognitive Dissonance.
Bystander Effect.
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Theories About the World
Deterministic Bias.
Hindsight Bias.
Attribution Bias.
Framing Bias.
All of the above biases contribute to underestimating the risk
associated with the decisions being made.
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Theories About Other People
Ethnocentrism
Thinking of ourselves and those most similar to us as better
than others.
US versus Them Mentality.
Our nation is better than any other nation.
Our Baseball team is better than any other team.
People who think and act like me are better than those that
don’t.
Stereotypes
Derived from ethnocentrism.
People often attribute negative attributes to those not similar to
themselves.
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Theories About Ourselves
Overconfidence/Superiority Bias.
Oversimplification Bias.
Loss Aversion Bias.
Authoritative Bias.
Conformity Bias/ Group Think.

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Incrementalism
The Slippery Slope.
Once you agree to do something unethical and or illegal once it
is more likely you will do it again.
Your past actions can be used against you in the future.
Often times presented as a ‘one time’ request or as being
‘immaterial’.
There is no concept of materiality when it comes to fraud.
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Situational Factors
Time Pressure
People tend to cut corners when under a deadline.
Transparency
The importance of Internal Controls – People do not respect
what you do not inspect.
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Leon Festinger
Recognized the limitation of philosophical reasoning
approaches integrated into decision making models.
How we think we should behave is different from how we
decide to behave.
Coined term of Cognitive Dissonance in 19 56.

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Cognitive Dissonance
Inconsistency between our thoughts, beliefs, or attitudes and
behavior creates the need to resolve contradictory or conflicting
beliefs, values, and perceptions.
Only occurs when we are “attached” to our attitudes and beliefs.
How we think we should behave is different from how we
decide to behave.
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Bystander Effect
Tendency not to report wrongdoing or try and help someone in
need thinking others will.
The New York City Subway Incident.
The Harvey Weinstein Case.
Countless other incidents of Sexual Harassment in the
workplace.
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Describe Kohlberg’s stages of moral development.
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Kohlberg and Cognitive Development
Psychologist.
20 years of research.
Moral reasoning processes becomes more complex and
sophisticated with development.
Higher stages are consistent with philosophical theories of
rights and justice.
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Heinz and the Drug
Heinz’s wife has a rare cancer.
A radium drug could help.
Druggist charged 10 times what drug cost ($200 cost; $2,000 for
small dose of drug).
Heinz could only get together $1,000.
Druggist would make no exceptions to price of drug.
What should Heinz do?
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Sample Responses to the Heinz Dilemma
Egoism: Steal the drug, depending on how much Heinz likes his
wife and how much risk to stealing.
Ends justify the means: Steal the drug, due to loving the wife so
much and cannot watch her die.
Act Utilitarianism: Weigh the costs and benefits of alternative
actions.
Rule Utilitarianism; justice: Do not steal the drug, since
stealing is against the law.
Rights: Right to life above all else (Constitutionally: life,
liberty, and the pursuit of happiness).

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Kohlberg’s Stages of Moral Development
Lawrence Kohlberg’s six stages of moral development are
divided into three levels of moral reasoning.
Level 1 – Preconventional.
Level 2 – Conventional.
Level 3 – Postconventional.
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Level 1 - Preconventional
Rules are seen as something external imposed on one’s self.
Individual is very self-centered.
Stage 1 – Obedience to rules; avoidance of punishment.
Stage 2 – Satisfying one’s own needs (egoism); follow rules
only if they satisfy one’s needs.
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Level 2 - Conventional
Individual becomes aware of the interests of others and one’s
duty to society.
Personal responsibility is an important consideration in decision
making.
Stage 3 – Fairness to others; commitment to loyalty in the
relationship.
Stage 4 – Law and order; one’s duty to society, respect for
authority, maintaining social order.

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Level 3 - Postconventional
Individual recognizes there must be a society wide basis for
cooperation.
Orientation to principles that shape whatever laws and role
systems a society may have.
Stage 5 – Social contracts; upholding the basic rights, values,
and legal contracts of society.
Stage 6 – Universal ethical principles that everyone should
follow, Kohlberg believed this stage rarely existed; Kant’s
categorical imperative.
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Characteristics of Kohlberg’s Model
Kohlberg maintains that his stage sequence is universal.
Same in all cultures.
Stages refer not to specific beliefs, but underlying modes of
reasoning.
Suggests that people continue to change their decision priorities
over time and with additional education and experience.
Individual’s moral development can be influenced by corporate
culture, especially ethics training.
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Explain Rest’s Model and how its components influence ethical

decision making.
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Moral Reasoning and Moral Behavior
Moral judgment is the single most influential factor of a
person’s moral behavior.
Morality requires.
Person’s actions be rational.
Motivated by purpose or intent.
Carried out with autonomous free will.
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Rest’s Model of Morality
James Rest’s model of ethical action is based upon the
presumption that an individual’s behavior is related to her/his
level of moral development. He breaks down the ethical
decision-making process into four major components.
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Components of Rest’s Model
Moral Sensitivity – ability to identify what is moral and amoral.
Moral Judgment – ability to reason through several courses of
actions and making the right decision when faced with an
ethical dilemma.
Moral Motivation – influences that affect an individual’s
willingness to place ethical values ahead of non-ethical values.

Moral Character – having one’s ethical intentions match actions
taken.
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27
Moral Intent
Critical component of ethical decision making.
Internalization of virtues.
Acting in accordance with principles.
One must want to make the ethical decision.
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Components Interact
All processes must take place for moral behavior to occur.
This framework is not a linear decision-making model, the
processes instead work through sequence of “feed-back” and
“feed-forward” loops.
Moral failure can occur when there is a deficiency in any one
component.
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Libby and Thorne: Virtues Important for Auditing
Intellectual virtues: indirectly influence individual’s intentions
to exercise professional judgment.
Most important: integrity, truthful, independent, objective,

dependable, principled, and healthily skeptical.
Instrumental virtues: directly influence individual’s actions.
Most important: diligent, alert, careful, resourceful,
consultative, persistent, and courageous.
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Linda Thorne’s Integrated Model of Ethical Decision Making
Access the text alternative for slide images.
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Describe the link between organizational culture, ethical
climate, ethical leadership, and ethical decision making.
32
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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. It is typically found in the Company’s Code of
Ethics.
Organizational ethical climate
Moral atmosphere and level of ethics practiced within a
company.

Importance placed on E D I.
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.
Creating a culture which actively promotes an inclusive work
environment that values diversity is essential.
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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Ethical Leadership: Tone at the Top
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
Employees follow the actions of their leaders over written codes
of conduct.
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Key Markers of Highly Ethical Organizations
Humility.
Zero tolerance for individual and collective destructive
behaviors.
Justice.
Integrity.
Focus on Equity, Diversity and Inclusion.
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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Distinguish between Equity, Diversity, and Inclusion.
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Equity, Diversion, and Inclusion (E D I)
E D I means to give each person the same opportunity,
accepting people from different races, genders, religions, and
nationalities.
E D I policies should promote ethical behavior and tear down
biases.
Promote justice and fairness.
Virtues of caring, kindness and empathy.
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Deloitte Survey: How to Create a Culture of Belonging
25% identified fostering an environment where workers feel
they are treated fairly and can bring their authentic selves to
work (feeling comfortable) as the biggest driver of belonging.
31% identified having a sense of community and identifying
with a defined team (feeling connected) was the biggest driver.
44% identified feeling aligned to the organization’s purpose,
mission, and values and being valued for their individual
contributions (feeling their contributions matter) was the
biggest driver of belonging at work.
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Deloitte Survey: Value of E D I efforts in the Workplace
72 % indicated that fostering a sense of belonging at work is
important.
93% indicated that a strong sense of belonging drives
organizational performance.
Unfortunately, only 13% indicated that they were ready to

address / make the changes necessary to foster belonging in
their organizations.
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Better Up Survey: Importance of E D I Efforts
Workplace belonging can lead to:
a 56% increase in job performance;
a 50% reduction in the risk of turnover;
And, a 75% decrease in the number of employees calling in
sick.
One single incidence of a micro-exclusion can result in a 25%
reduction in productivity.
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Factors that Influence Ethical Decision Making
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.
Ethical Dissonance
The Organizational to Individual Fit.
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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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.
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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Ethical Dissonance Model 2High Organization Ethics
&
Low Individual EthicsHigh Organizational Ethics
&
High Individual EthicsLow Organizational Ethics
&
Low Individual EthicsLow Organizational Ethics
&

High Individual Ethics
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Apply both the Integrated Ethical Decision-Making Model and
the Giving Voices to Values Methodology to a case study.
46
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Accountants Ethical Behavior
Accounting profession has professional standards to encourage
ethical behavior.
These standards, an individual’s attitudes and beliefs, and
ethical reasoning capacity influence professional judgment and
ethical decision making.
Post conventional reasoning is the ethical position to take even
though it may go against corporate culture of, “go along to get
along”.
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Ethical Domain in Accounting and Auditing
Four key constituent groups of accountants and auditors’
domain are the:
Client organization that hires and pays for accounting services.
Accounting firm that employs the practitioner.
Accounting profession including various regulatory bodies.
General public who rely on the attestation and representation of
the accounting firm.

48
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Empirical Studies
Studies have shown that:
Ethical reasoning may be an important determinant of
professional judgment.
Unethical and dysfunctional audit behavior may be
systematically related to the auditor’s level of ethical reasoning.
Ethical reasoning may be an important cognitive characteristic
that may affect individual judgment and behavior.
49
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Ethical Decision-Making Models
Consciously thinking about and analyzing what one has done (or
is doing).
A systematic process to organize the various elements of ethical
reasoning and professional judgment.
Evaluate stakeholder interests.
Analyze the relevant operational and accounting issues.
Identify alternative courses of action.
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Integrated Ethical Decision-Making Process
Identify the ethical and professional issues (ethical sensitivity).
Identify and evaluate alternative courses of action (ethical
judgment).
Reflect on the moral intensity of the situation and virtues that

enable ethical action to occur (ethical intent).
Take action (ethical behavior).
51
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Ace Manufacturing
Three stockholders: Smith, Williams, & Jones.
Jones hires son Paul to manage the office.
Paul is given complete control over payroll, approves
disbursements, signs checks, reconciles G/L cash to bank
statement.
Paul hires Larry Davis to help with accounting.
While Paul is on medical leave, Davis finds $10,000 total in
payments over payroll amount to Paul in January and February.
What should Davis do?
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Application of Decision-Making Model to Ace Manufacturing 1
Identify the ethical and professional issues (ethical sensitivity).
G A A P – Potential fraud, misstated F/S, incorrect taxable
income.
Stakeholders – owners, Paul, Davis, I R S, banks.
Ethical/professional standards – objectivity, integrity, due care.
Identify and evaluate alternative courses of action (ethical
judgment).
Legal issues – G A A P, fraudulent F/S, tax understatement.
Alternatives/ethical analysis – do nothing, confront Paul, report
to Jones or all the owners. Rule utilitarianism and rights argue
for informing other partners who have a right to know, although
Paul can be approached first under the theory he has a right to
correct the matter.

53
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Application of Decision-Making Model to Ace Manufacturing 2
Use Ethical Reasoning to evaluate the alternative courses of
action.
Will Davis be responsible for getting Paul in trouble?
What is the right thing to do?
Can Davis trust Paul again?
Davis needs to maintain Integrity and avoid cognitive
dissonance.
Take action (ethical behavior).
Have courage, insist on correction to accounting, give Paul an
opportunity to explain.
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Giving Voice to Values
Behavioral ethics approach with an emphasis on developing the
capacity to effectively express one’s values in a way that
positively influences others.
Finding levers to effectively voice and enact one’s values.
Ask to think about the arguments others might make that create
barriers to expressing one’s values in workplace.
Ask to think how best to counteract these “reasons and
rationalizations”.
Used post-decision making (already decided what to do).
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G V V Questions
How you get it done effectively and efficiently?
What do you need to say, to whom, and in what sequence?
What will the objectives or pushback be, and, then.
What will you say next?
What data and examples do you need to support your point of
view?
G V V relies on developing arguments, action plans, and
rehearsing how to voice/enact moral values.
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Reasons and Rationalizations
Expected or Standard Practice – “Everyone does this”.
Materiality – “The impact is not material. It doesn’t really hurt
anyone”.
Locus of Responsibility – “This is not my responsibility; I’m
just following orders”.
Locus of Loyalty – “This is not fair to the client, but I don’t
want to hurt my reports/team/boss/company”.
Isolated Incident – “This is a one-time request”.
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4 – Step G V V Process
What are the main arguments you are trying to counter? That is,
what are the reasons and rationalization you need to address?
What’s at stake for the key parties, including those with whom
you disagree?
What levers can you use to influences those with whom you
disagree?
What is your most powerful and persuasive response to the

reasons and rationalizations you need to address?
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Ace Manufacturing Analysis with G V V 1
What are the main arguments to counter or reasons and
rationalizations to address?
No one hurt, private company, sympathy card, materiality, not
being compensated properly, isolated incidents, Jones has
approved, will pay back.
What’s at stake for the key parties?
Reputations, embarrassment, right to know, loss of job, ability
to obtain loan.
59
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Ace Manufacturing Analysis with G V V 2
What levers can you use to influence those with whom you
disagree?
Ask for supporting documents for coding of expenses, harm to
company and embarrassment to dad, long-term effects, telling
all the owners.
What is your most powerful and persuasive response to the
reasons and rationalizations?
Verifying that vendor is not paid twice, using money for
personal use is stealing and no materiality test, challenges Jones
about knowing, owners need (have a right) to know.
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Concluding Thoughts/Key Issues
“The road to success is littered with failures, but the lessons
learned are crucial in plotting your course to success.” Kristi
Loucks.
Kohlberg’s model of moral development.
Rest’s model of ethical decision-making.
Cognitive development.
Issues of moral intensity and virtue in Integrated Decision-
Making mode.
Behavioral ethics.
Moral reasoning skills.
Giving Voice to Values.
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Video Links
Ethics Relationships.
Baby Lab.
Personal Behavior.
Case 2-10 WorldCom.
Cynthia Cooper interview.
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Case 2-1 A Team Player? (a GVV case)
Barbara is working on the audit of a client with a group of five
other staff-level employees. After the inventory audit was
completed, Diane, a member of the group, asks to meet with the
other employees. She points out that she now realizes a
deficiency exists in the client's inventory system whereby a
small number of items were double counted. The amounts are
relatively minor and the rest of the inventory observation went
smoothly. Barbara suggests to Diane that they bring the matter
to Jessica, the senior in charge of the engagement. Diane does
not want to do it because she is the one responsible for the
oversight. Three of the other four staff members agree with
Diane. Haley is the only one, along with Barbara, who wants to
inform Jessica.
After an extended discussion of the matter, the group votes and
decides not to inform Jessica. Still, Barbara does not feel right
about it. She wonders: What if Jessica finds out another way?
What if the deficiency is more serious than Diane has said?
What if it portends other problems with the client? She decides
to raise all these issues but is rebuked by the others who remind
her that the team is already behind on its work and any
additional audit procedures would increase the time spent on the
audit and make them all look incompetent. They remind Barbara
that Jessica is a stickler for keeping to the budget and any
overages cannot be billed to the client.
Explain what Barbara should do if she reasons at each of the
stages of Kohlberg’s model.
(no less than 150 words)

Case 3-2 Rite Aid Inventory Surplus Fraud
Occupational fraud comes in many shapes and sizes. The $12.9
million dollar fraud and kickback scheme at Rite Aid is one
such case.
In February 2015, Jay Findling, a New Jersey businessman,
pleaded guilty to charges of conspiracy to commit wire fraud.
Former vice president, Timothy Foster, pleaded guilty to
making false statements to authorities. On November 16, 2016,
Foster was sentenced to five years in prison and Findling, four
years. Findling and Foster were ordered to jointly pay
$8,034,183 in restitution. Findling also forfeited and turned
over an additional $11.6 million to the government at the time
he entered his guilty plea. In sentencing Foster, U.S. Middle
District Judge John E. Jones III expressed his astonishment that
in one instance at Rite-Aid headquarters, Foster took a
multimillion dollar cash pay-off from Findling, then stuffed the
money into a bag and flew home on Rite Aid's corporate jet.
The charges relate to a nine-year conspiracy to defraud Rite Aid
by lying to the company about the sale of surplus inventory to a
company owned by Findling when it was sold to third parties
for greater amounts. Findling would then kick back a portion of
his profits to Foster. Foster's lawyer told Justice Jones that,
even though they conned the company, the efforts of Foster and
Finding still earned Rite Aid over $ 100 million "instead of
having warehouses filled with unwanted merchandise."
Assistant U.S. Attorney Kim Daniel focused on the abuse of
trust by Foster and persistent lies to the feds.
"The con didn't affect some faceless corporation, Daniel said,
"but harmed Rite Aid's 89,000 employees and its stockholders."
Findling's attorney, Kevin Buchan, characterized his client as "a
good man who made a bad decision." "He succumbed to the
pressure. That's why he did what he did and that's why he's
here," Buchan said during sentencing.
Findling admitted he established a bank account under the name

"Rite Aid Salvage Liquidation" and used it to collect the
payments from the real buyers of the surplus Rite Aid
inventory. After the payments were received, Findling would
send lesser amounts dictated by Foster to Rite Aid for the
goods, thus inducing Rite Aid to believe the inventory had been
purchased by J. Finn Industries, not the real buyers. The
government alleged Findling received at least $127.7 million
from the real buyers of the surplus inventory but, with Foster's
help, only provided $98.6 million of that amount to Rite Aid,
leaving Findling approximately $29.1 million in profits from the
scheme. The government also alleged that Finding kicked back
approximately $5.7 million of the $29.1 million to Foster.
Assume you are the Director of Internal at Rite Aid and
discover the surplus inventory scheme. Explain the steps you
would take to determine whether you would blow the whistle on
the scheme by applying the requirements of Exhibit 3.15 on
subordination of judgment. In that regard, answer the following
questions.
Assume you have decided to report the fraud. What would your
first step be? That is, to whom would you report the fraud and
why?
(no less than 150 words)

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