Boston Chicken Case Study

Chapter 1 Fraud

1. Definition of Accounting Fraud

1. Lawrence and Wells “Under common law, three elements are required go prove a fraud: a material false statement made with an intent to deceive… a victim’s reliance on the statement and damages.”
2. FBI “The intentional perversion（曲解） of the truth for the purpose of inducing another person or other entity in reliance upon it to part with something of value or to surrender a legal right.”
3. Center of Audit Quality “a material misrepresentation resulting from an intentional failure to report financial information in accordance with GAAP.”
4. For civil cases the burden is a “preponderance of evidence.” In criminal fraud the standard is “beyond a reasonable doubt.”

1. Criminal Accounting Fraud

Most of criminal corporate fraud investigated by the Financial Crimes Section (FCS) of the FBI involves financial reporting fraud.

1. Gatekeepers who failed (Worldcom as an example)

1. Board of Directors

• Lack of independence
• Too few external directors
• Compromised relationships with outside directors
• General oversight failure
• Audit Committee
• Compensation and stock-option committee

1. Internal Audit Departments

• Too few resources
• Reporting to the same managers they have to audit
• Sometimes ex-employees of external audit firms

1. External Auditors

• Appearance versus fact of independence
• Auditors joining clients firms
• Ownership of shares in client companies

1. Investment Bankers

• Correlation between receiving business and allocating “Friends of the Company” shares
• Due diligence尽职尽责
• Instructing analysts to “give” favorable ratings of stock

1. Management, Accounting Staff, and Internal Control

• AAER’s show how frequently management misstated financial statements to meet analysts’ earnings expectations
• Increase in percentage of compensation composed of stock option
• Value of options not expenses on the income statement
• Inadequate internal control system
• Unclear auditing obligations regarding internal control

1. The Sarbanes-Oxley Act of 2002

Some of the main areas of corporate governance reform as a result of the SOX Act of 2002 include:

• Internal control requirements (SOX Sect 404)
• Responsibilities of corporate management (Sox Sect 302)
• Loans to executives
• Independence and oversight of external auditors
• Audit committees
• Independence of boards of directors
• Independence of analysts
• Corporate crime enforcement

1. The Dodd-Frank Act of 2010

The SEC rules in response to Dodd-Frank:

• Rules concerning shareholder approval of executive compensation
• Rules that have already resulted in approx.. 1200 hedge fund and other private fund advisors registering with the SEC
• A whistle blower program
• Increasing dramatically investors’ visibility into the asset underlying all types of asset backed securities
• Requiring securitizers, to keep skin in the game, giving them an incentive to double-check originators’ underwriting practices
• Changing the practices of the rating agencies whose gross mis-ratings of billions of dollars of mortgage-backed securities were kerosene on kindling

1. Improper Revenue Recognition

1. Improper timing of Revenue Recognition

1. Holding books open after close of a reporting period
2. Bill-and-Hold, Consignment Sales, and other Contingency Sales
3. Multiple Element Contracts or Bundle Contracts

            b. Fictitious Revenue

1. Improper Expense Recognition

1. Improper Capitalization/deferral—Failure to record expenses or losses:

1. Improper Capitalization of Expenses or Losses
2. Improper Deferral of Expenses or Losses
3. Failure to Record Expenses or Losses

1. Overstating Ending Inventory Values
2. Improper Use of Restructuring and Other Liability Reserves
3. Understating Reserves for Bad Debts and Loan Losses
4. Failure to Record Asset Impairments

1. Improper Accounting in Connection with Business Combination

1. Improper Asset Valuation
2. Improper Use of Merge Reserves
3. Inappropriate Application of Purchase/Pooling Methods

1. Other Areas of Improper Accounting

1. Inadequate Disclosures in Management Discussion & Analysis (“MD&A”) & elsewhere in Issuer Filings
2. Failure to Disclose Related Party Transactions
3. Inappropriate Accounting for Non-monetary and Roundtrip Transactions
4. Improper Accounting for Foreign Payments in Violation of the FCPA
5. Improper Use of Non-GAAP Financial Measures
6. Improper use of Off-Balance Sheet Arrangements

Ethics

1. Theories of Ethics

• We can distinguish three major ethical theories or schools of thought as to what is most important in the pursuit of morality—namely, consequentialism归结主义, deontological道义论, and virtue morality.  
• To the consequentialist, the most important issue in morality is to choose the right action and this choice is determined by examining the consequence of that action
• To the deontologist, the most important issue in morality is to do the right thing because it is right or, as it is often stated, “do your duty for duty’s sake”
• Under this view, if it is right to be honest, then avoiding lying and telling the absolute truth is always right, irrespective of the consequence
• The virtue ethicists hold that the most important aspect of morality is having the right character or set of traits or “dispositions” as they are often called
• According to virtue ethicist, possessing the right set of virtues is central to morality, because what makes an action right is that it is the action that a virtuous person would take

1. Consequentialism

• The term consequentialism refers to all the approaches to the study of morality that judge conduct or actions in terms of the consequences that they produce
• The leading and best-known form of consequentialism is identified as utilitarianism
• (Jeremy Bentham) Utilitarianism holds that the right action ethically is the action that maximize the “good”
• Bentham thought that there was only one “good”, namely pleasure, and one “evil”, namely pain
• Bentham’s protégé门徒, John Stuart Mill, defined happiness as the presence of pleasure and the absence of pain, and believed that actions have utility when they maximize happiness
• According to Mill, actions are right in proportion to the happiness they tend to promote, and the morally best actions of those open to us is the action that maximizes happiness, or (in his sense) has utility
• As consequentialist philosophy has developed over years, different philosophers, have specified different definitions of the “good” or what ought to be maximized, but the unifying thread is that they all judge actions according to the sum of the net “good” that they cause among all affected by the actions
• Other forms of consequentialism focus on the proportion of benefits to costs caused by actions, some testing actions by their benefits to the nation (nationalism), or their effects on a utility such as knowledge (epistemism 认知), or benefits for oneself only (egoism)

1. Deontology

• The deontologist does not look to the future or the effect of actions in order to judge an action as right or wrong
• Moral actions is chosen not because of its consequences, but because it is the right thing to do
• Deontologists assert that one must do the right thing because it is one’s duty to do the right thing
• The leading deontologist is Immanuel Kant
• Kant goes even further by saying that if you perceive telling the truth as a duty, you must always tell the truth for that reason in itself
• Furthermore, you must tell the truth even if telling the truth could cause a negative consequence
• Kant’s standard test is that one ought to act as though a personal maxim were a universal moral law and you can stipulate that law for everyone without it leading to “contradiction”
• Finnis presents Kant’s three formulations of the categorical imperative:

• Act only according to that maxim by which you can at the same time will it should become a universal law
• Act so that you treat humanity, whether in your own person or in that of another, always as an end and never as a means
• Act according to a maxim which harmonizes with a possible realm of ends

1. Ethics (Continued)

The three major ethical theories can be distinguished by their answer to the question, “What is the most important aspect of morality?”

• Both utilitarian and deontologists look outside of the individual, i.e. outside of the decision-maker, to determine the answer to the question
• The utilitarian or consequentialist focus on the consequences of the action to establish the morality of the action
•  The deontologist insists that morality is determined by doing one’s duty at all the time, and an examination of the outer world ascertains what that duty is
• In the virtue theory of ethical behavior, the most important aspect of morality is found within the individual
• According to this philosophy of virtue ethics, having the right character is the most important aspect of morality

1. Virtue Ethics

• Here the most important issue in morality is having the right “set of dispositions” or virtues
• In other words, having a moral character is the basis for choosing the right actions—a person of fundamental integrity can be trusted to do the right thing
• Cohen (2004) describes this as follow:  

A virtue ethics view may see the process more “insight out.” Moral behaviors should be the result of, and flow from, a person’s character. This is not only say that moral behavior is only automatic or spontaneous. It can indeed involve difficult and perplexing thinking and deliberation. Cultivation of an ethical person, then, is very largely a matter of developing the right character.

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