Unethical Behavior of Auditors

Term Paper, 2015

53 Pages


Table of Contents

Chapter 1 - Introduction
1.1 Purpose of the research
1.2 Importance of the research
1.3 Aims and objectives of the research
1.4 Limitations of the research
1.5 Background History
1.6 How is project arranged

Chapter 2 – Literature Review
2.1 Ethics
2.2 Ethics – definition
2.3 Ethics Separation
2.4 Corporate Moral Governance
2.5 Internal Audit – historical background
2.6 Deontology code
2.7 Falsification of financial statements - definition, motivation and consequences
2.8 Where the phenomenon of falsification appears
2.9 Methods of falsifying financial statements and direct effects
2.10 Who are independent auditors and which is their job.
2.11 Auditors’ responsibility – Internal and external control
2.12 Internal audits through the use of electronic information systems
2.13 Strong corporate culture
2.14 Rewards for right attitude and direct punishment for inappropriate behavior
2.15 System of information and communication
2.15.1 Information
2.15.2 Communication
2.15.3 Whistleblowing
2.16 Internal audit committee
2.16.1 Effective operation of the Audit Committee

Chapter 3 – Research Methodology
3.1 Research design and Data Collection

Chapter 4 - Data analysis

Chapter 5 – Conclusion



The object of the current study are the challenges that auditors face and the falsification of financial reports something that occurs quite often recently. The term “falsification of financial reports” refer to the intentional change of financial data aiming at the over-evaluation of asset, sales and profits or undervaluation of expenses and damages so as to achieve the desired result. Therefore, they manage to alter the image of financial reports.

By using a representative sample of 32 companies whose stocks are negotiated at the Stock Exchange, it is sought to comprehend the phenomenon of falsification and naturally, by using the right literature.

The aspects of falsifying financial statements as well as its consequences are many and can be economic, social, political, moral, but also legal.

The role of the auditor and its behavior are crucial since there is the necessity of having moral quality which will be based on the controlling services of high quality internal control which consists the final result of the study.

Key words: auditor, behavior, falsification, over-evaluation, moral quality.

Chapter 1 - Introduction

Both in USA and in Europe, the falsification of financial reports is an issue of concern for auditors.

In such falsification, the executives of the company but also auditors and banks are involved. This phenomenon is called “accountancy fraud”.

Creative accountancy is the one use to falsify financial reports. According to the International Accounting Standards, the term falsification refers to the effort of one or more individuals that is done on purpose by the management of the company aiming at falsely presenting financial reports. The term accountancy fraud refers to the falsification of entries, wrong presentation of assets, bad implementation of accounting standards (Rawls, 2007).

In the present research is examined the unethical behavior of auditors whereas falsification is part of it.

1.1 Purpose of the research

The purpose of the research is to present cases of possible unethical behavior of auditors in some Greek companies. More specifically, it was examined the consequences of applying International Accounting Standards in these companies.

1.2 Importance of the research

The research importance lies to the fact that there are very few studies concerning the role of auditor and the consequences of its behavior in examining financial statements. Therefore, the present research will contribute to the existing literature on auditing and specifically literature regarding Greek companies.

1.3 Aims and objectives of the research

The present research deals with the consequences on financial reports when International Accounting Standards were implemented after 2005 (Rawls, 2007). There was conducted an empirical research on a sample of 32 companies for the period of 2002-2007 and objective was to find out if there were any consequences on the implementation of International Accounting Standards and auditors’remarks for them.

1.4 Limitations of the research

There were serious time constraints and this was mainly due to the limited time available to study more data. The sample was quite small and it would have been better if there was a larger sample, however, time available was restricted. A larger sample would also mean that the researcher would have to access more companies, a fact that would make the present research more expensive and the researcher could not finance it further due to budget constraints.

1.5 Background History

The goal was to search as many fields as possible and examine companies that their stocks are traded in the Stock Exchange.

1.6 How is project arranged

The first chapter concerns the introduction and the goal and limitation of the research. The second chapter includes the literature review, the third chapter is the methodology of the research, the fourth chapter is data analysis and results and finally, the fifth chapter concerns conclusions and recommendations.

Chapter 2 – Literature Review

2.1 Ethics

Ethics is an issue of concern for humanity for thousands of years. As a concept, it has been evolved during the years and nowadays, it impacts corporate perception and the way companies understand perception. Aristotle was the first one who found the terms and attributed to it the virtues on which human actions are based on. It is a code of behavior or beliefs that the society considers as valid and shapes what is right or wrong.

It is also “common perceptions…ethics that have been changed significantly during time” and interact with the geographical, technological and cultural environment.

From a regulatory point of view, morals shape a code of behavior and beliefs. Ethics expresses value judgments on the distinction of evil/good and seeks to determine the meaning of human life as well as the means for achieving this goal. Morals differ from one nation to the other, they depend on their tradition and the degree of development of each one.

According to the Ethics Laws (Gillon, 1986), the individual should act on the benefit of everyone, protect life and not destroy it, respect the personality and the fortune of others.protect and help the weak one and finally, s/he should be useful to other people, not be vengeful and sacrifice for the other ones. According to Rawls, there are limitations in the concept of right from the moment they succor during the selection of moral principles. People should examine all moral dilemmas that derive from the framework of partial compliance theory, in the framework of freedom. Social justice is a value that is not opposed to individual freedom, but it presupposes and includes it. The individual to end up in a totality of principles for social welfare, it should be distanced from his/her selfish interests which prevail. The individuals should follow the principle of welfare maximization of those who are in a worse position and would not have been very willing to accept changes that would reduce their personal welfare (Rawls, 2007).

2.2 Ethics – definition

Many definitions have been given for ethics. It is the study of morals (values, perceptions, behaviors) of a society and by extension the system of thought and behavior that rules the actions and behavior of a society at a specific time and space. Ethics could also be determined as a set of personal values that leads the individual’s actions. It is a continuously evolved behavior code that depends on the circumstances and experiences of the life of individual. Professors George and John Steiner suggest that it is “the study of good and evil, right and wrong, fair and unfair”. However, good, right and fair is controversial and cannot be determined easily. Ethics, in addition, is an implementation of moral principles in selecting the decision between right and wrong (Rushton, 2002).

The fundamental concept of ethics is represented by the word “good” and “duty”. Good is distinguished in good as means and good as goal (Dempsey, 2000). Socrates suggested that the first and main function of ethics is to determine moral terms and only the knowledge of the definitions of virtue makes human really virtuous. Consequently, ethics approaches the concept of goodness (which is closer to a theological concept of supreme goodness) and the concept of duty (which is closer to the social perception of responsibilities within society).

2.3 Ethics Separation

The science of moral coercion is divided in three individual categories: normative ethics, meta-ethics and applied ethics (Dempsey, 2000). Normative ethics attempts to establish the rules or behavioral standards (Newall, 2005). The theories that adopt this base of ethics are divided in four categories (Tsaliki & LaTour, 1995):

- Consequential or teleological theories are the theories that deal exclusively with the consequences of the action.
- Non-consequential or deontological theories are the theories that deal exclusively with the action.
- Hybrid theories are the theories that are consisted of a mixture of elements both of teleological theory as well as of deontological theory.
- Ethics relativism is the concept of moral correlation which is reflected on the dual perception of the Greek philosopher Protagoras (5o century B.C). First, the moral rules are not applicable on all kinds of people and secondly, people tend to follow the behavioral rules of their peers.

2.4 Corporate Moral Governance

The term governance is defined as “how to run the business of the state” meaning that business people have to implement the rules of the logic and the scientific method. European Commission defined it as the “structure of rules and processes that impact on the practice of power, which should be practiced openly, with participation, accountability, effectiveness and cohesion. These principles are important for setting up a more democratic governance and which could be implemented on all governance levels” according to the White Bible for Environmental Responsibility (Brussels, 2000). Governance is consisted of systems where the one influences the other and should be open to the communication of its subsystems, following at the same time the principles of transparency, consultation, effectiveness, goal achievement, the principle of necessity and the principle of proportionality. It includes rules and procedures, without using violence or practicing the latter in exceptional cases. These rules are the ones that transform the power into legitimized power (according to Weber) and are the trait of good governance.

Corporate governance is the set of rules that govern the relations of all participants and all those that are affected by the operation of the company. Its goal is the maximization of the value of the business in the benefit of its stakeholders, those that contribute to its influence and society in general. It is based on internal audit which assesses and records internal processes, points out weaknesses and deviations of the system, provides advice and suggests adaptations. It contributes to the development and consolidation of the corporate culture among its executives and the adaptation of the business in the existing institutional framework. It actually contributes to the protection of the company and the ensurance of the stakeholders interests (Singh, 2002).

Corporate governance is based on the corporate and financial law, accounting rules, business practices and the deontology of each country. Its main goals are to facilitate and enforce performance by establishing a system of rule that encourage administrators to maximize business efficiency. Following, it eliminates power abuse on the side of executives regarding company sources which derive from the tendency of executives to serve their own interests. In addition, it provides the tools of supervision of the behavior of executives so as to guarantee the responsibility of the business and protect in any way the interests of the investors and the company from possible abuse (Roux, 2007).

Corporate ethics deals with the company treatment in the environment and society so as to promote corporate profit, social interest, progress and creativity. The term causes the reaction of the fanatic supporters of the free market as well as its adversaries. The first wonder if the business should be preoccupied with ethics and not with the increase of its profits. Therefore, ethics has no relation with businesses. The second support that by definition is not possible for a business to be moral since it uses every mean, fair or unfair, to succeed in the desired for it profitability. Berkley professor, Robert Reich, supports that businesses should be in a position to bring the property of corporate citizen, but they should neither participate in shaping public policies mainly because their goal is to profit maximization.

2.5 Internal Audit – historical background

Internal audit dates back thousands of years ago by the Greeks, Romans and Egyptians to carry out audits in the BC period. And at that time, they were examining the correctness of the accounting entries. As historian Richard Brown (1905) stated, «the beginning of the audit daties well before accountancy,» thus he shows the innate need to control all activities of people

The first US Congress passed an act in 1789 that included a provision for the appointment of a Secretary to the Treasury, a controller and an auditor. The controller's responsibilities were to receive all public accounts, to examine and certify their balances. The American railway companies were the first to hire internal auditors at the end of the 19th century, to check the ticket agents and determine the proper money management. The Krupp company was among the first companies that hired internal auditors, as indicated by the date of the audit manual (17 January 1875.

The proliferation of large companies, in the early 20th century, led to the need for extensive control of the large number of employees in these enterprises. However, the problems in the management of accounts and the increase in the volume of transactions led these companies to the delegation of their control by public auditors. The aim of the first internal auditors was primarily, the protection of assets. The auditors were focused on examining financial data and verification of assets that were easier to be misappropriated.

An internal audit program was used as a psychological deterrent against wrongdoing by employees The shift to a war economy in the early 1940s was the main reason for the expansion of the scope of internal audit (Roux, 2007). Special attention was given to planning, material management and employees, in compliance with regulations and cost report. As a result, internal auditors began to direct their work towards management. The internal auditors are now an integral part in the management process and the main objective of the audit process has been shifted from the detection of fraud to the evaluation of the risks of a business, and help management in decision making.

2.6 Deontology code

The deontology code refers to a set of formal behavior rules, flags the direction of economic action and business behavior. It is a written statement which determines precisely corporate principles, ethics, behavioral codes and business philosophy. It refers to the accountability that concerns employees, shareholders, customers, the environment and every other part of the society (stakeholders). It also defines a set of common values aiming at providing business with an identity and business culture, vision, compliance standards and transaction-negotiation rules with all those having legitimate interest for the business (Singh, 2002). It delimits issues that are classified in three categories:

a) The moral behavior among executive and treatment of the internal conflicts both on personal and professional level.
b) The obligations of supreme financial executives for composing and presenting financial reports
c) The implementation and compliance with the rules and limitations set by supervision authorities.

The code is an integral part of corporate governance for achieving transparency in business operation and the prevention of immoral actions through the establishment of behavior rules and expansion of the mission, vision, strategies and business values.

2.7 Falsification of financial statements - definition, motivation and consequences

It is surprising that throughout the international academic literature there is no precise definition for the term falsification of financial statements. Kazantzis (2006) considers that falsification is a phenomenon that can be attributed with various ways. Spathis (2002), for example, believes that in any financial situation there are errors or omissions during their redaction, which has as a result the distortion of the true picture of the business, is falsification.

Nevertheless, the term falsification and the term accounting error are two completely different terms. The International Accounting Standard No. 240 specifies that falsification of financial statements is a voluntary, deliberate action by individuals mainly executives but also employees, which results in a false presentation of financial statements. In addition, the term fraud is defined as distortion or alteration of accounting entries, altered presentation of assets, hide or miss the results of accounting records, registration of virtual transactions and finally, abusive implementation of accounting principles and standards.

In 2005 Razaee Z. in his book says that fraud by falsifying financial statements is considered a deliberate attempt to deceive, on the side of businesses in order to mislead users (investors, creditors) .

Wallace (2010) says that falsification is a form of actions designed to lead to misleading and which can be implemented with forged documents and illustrations that support the manipulation of financial statements.

Thomson (2005), based on a research by Beneish, defines falsification as the use of various forms of a number of smart innovations for distorting the financial performance of a company to achieve the desired result.

A different view is suggested by the company ALC Services ltd. In 2005, it reports the term "clerical falsification" which it defines as "the use of the occupational status of an employee for personal benefit and enrichment through the deliberate and intentional, improper or incorrect application of the sources and uses of a business”.

In summary, it could be suggested that falsification is considered something that is done deliberately in order to gain illegal profit.

The incentives that can make someone to falsify the financial statements are primarily of a financial nature intended to attract new investors. Incentives can also show the ideological foundations of the business and the egocentricity of the management wishing to make the business leader in its field of activity.

The effects appear in the relationships that the company has with the investors, creditors and financial institutions with which it cooperates. The discrediting of the business name leads to a lack of reliability and hence the fall in the value of its stock. This can also result in placing the company under control for a quite a large period of time. However, there are fines and even penalties of imprisonment for executives who have been involved.

2.8 Where the phenomenon of falsification appears

The falsification of financial statements is a phenomenon that concerns all businesses irrelevant of their field of activity. They are mostly, however, companies that are activated in the real estate industry, in industry, in financial institutions, oil companies but also companies that do business in the health industry. In recent years there have even been falsifications and in the industry of digital economy. Due to international trade, the phenomenon spreads in most countries. The ultimate purpose of falsification is to attract capital by improving the image of their company. Large companies have a special ability to absorb their losses.

According to Stalebrink and Sacco (2005) the falsification of financial statements is a subject that does not only concern private sector enterprises but also public sector ones as well as the ones of non – profitable nature. They also argue that if in the private sector the problem mainly takes economic dimensions, in the public sector is mainly political, in order to present a virtual surplus. Greenle, Fischer, Gordon and Keating (2005) argue that what repels each suspicion is the social face of the company, lax accounting audits and lack of entrepreneurial experience.

2.9 Methods of falsifying financial statements and direct effects

As falsification techniques are considered techniques used by companies through their cooperation. This may be a virtual buying and selling in firms with the same activity or sales presentation advances to their accounts in the form of sales already made.

However, since more than one businesses are involved, there should be a very good cooperation between the two or more administrations.

Accounting fraud does not necessarily mean that starts with an illegal practice. As it was rightly mentioned by Dooley (2002) «When it comes to a fraud by falsifying financial statements, the human imagination is common to invent myriad combinations of accounting irregularities to deceive investors.»

Methods used are the over-invoicing of sales, use of spending calculus 1% or 2% of sales without documents in export or tourism businesses, deliberately delayed of issuing invoices (especially towards the end of the closing year) and the failure to issue invoices so as to value added tax not to be paid.

The techniques that mainly appear in the falsification are located mainly in intangible and tangible fixed assets, participations and long-term requirements.

In the fixed assets such as land, no amortizations are made thus the value of assets is changed. Indeed, this type of manipulation can affect even financial ratios, such as ROI ratio which refers to the performance of business invested capital..

The business in order to succeed to beautify its results by showing increased profits, it will not conduct depreciation or even if it does, it will use reduced rates. Baraxelis (1998) emphasizes that the process of depreciation is particularly important because it is a source of funding for the company, since the amounts that correspond to amortization are not taxed and the company keeps them as reserves.

Intangible assets in order that businesses achieve a growth in profits, they transfer their accrued expenses in the account of Assets "Intangible assets and expenses of multiannual contract”.

By transferring interest rates on the product cost instead of period cost, earnings will increase since the product cost is incorporated into the product and is stored, thus there will be charges in the income statement when it is sold.

In intangible assets such as goodwill, the legislation defines that they are depreciated once in a financial year or within five years. The companies, however, in order to build the image of the results of the financial year change the time of amortization in only one financial year something that results in a clearly improved image of the results of the financial year.

Most of the company managers in order to improve liquidity ratio transfer holdings in securities which are however,current assets. Therefore, the ROI ratio appears in higher levels.

On long-term demands is transferred the bulk of requirements on short-term receivables so as to be an increase of the ratio of immediate liquidity. The total assets remain unchanged.

There is another method used by businesses to falsify their financial statements. The businesses value their obsolete merchandise at cost rather than the selling price. So the losses do not appear something that means increased profits. Victim in this technique is the efficiency ROI and general liquidity ratio.

The change in valuation methods from LIFO to FIFO is a method of falsification aiming at affecting the value of the final inventory and cost of sold as well as the balance sheet and income statement (Stathis et al., 2002).

But surely there are many ways that manage to falsify the financial statements in a way that is not easily understood and the managers of the companies suggest ways that are able to improve the image of the company with not always truthful information.


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Unethical Behavior of Auditors
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unethical, behavior, auditors
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Fotini Mastroianni (Author), 2015, Unethical Behavior of Auditors, Munich, GRIN Verlag, https://www.grin.com/document/358035


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