ETHICAL ISSUES RELATED TO ADMINISTRATIVE PROCESSES AND REPORTING (STUDY OBJECTIVE 7)
As in any business process, unethical or fraudulent behavior can occur in administrative processing and the reporting functions of an organization. However, in the process described in this chapter, unethical and fraudulent behaviors are much more likely to be initiated by management, not employees. Employee fraud is more prevalent in the routine processes of sales, purchases, payroll, and other processes described in previous chapters, while management fraud is more prevalent in administrative processes and reporting. There are several reasons that unethical and fraudulent behavior would tend to be management- rather than employee-initiated.
First, in a properly controlled system of administrative and reporting functions, employees do not have access to related assets or source documents. A review of the previous chapters reveals processes where employees have daily access to assets, source documents, and records. In processes related to sales, purchasing, and payroll, employees have access to assets such as inventory and cash. In addition, employees have access to source documents or records that can be fraudulently used. As examples, employees can inflate hours in their time card, steal cash or checks if they work in the mail room, steal inventory if they work in the warehouse, or process fictitious vendor payments if they work in accounts payable.
Second, administrative processes are tightly controlled and supervised by top management, as they require specific authorization. Employees do not have the authority to approve or initiate processes such as capital sources and investing. However, in processes such as sales, purchasing, cash receipts, and cash disbursements, employees are given general authorization to initiate and process transactions. This general authority can allow employees to initiate fraudulent transactions. Many relevant examples have been described in previous chapters, but another example may illustrate employee fraud when general authorization exists: If an accounts receivable employee is given general authorization to write off uncollectible accounts, that employee might write off the account of a friend or relative even when it could be collected.
Finally, a huge volume of transactions is often generated by sales, purchasing, payroll, and conversion processes. The routine nature and volume of these processes make it easier for employees to hide fraudulent transactions or unethical behavior within the masses of transactions. As an analogy, think about the differences in very large classes and very small classes. The large classes with hundreds of students create an atmosphere that makes it easier for an individual student to remain anonymous, to not read material for class, to sleep in class, or to cheat on exams or assignments. However, the intimacy of smaller classes makes it much harder to hide such behaviors. Likewise, the huge volume of transactions in routine processes makes it easier to hide fraudulent or unethical behavior. Administrative processes are nonroutine, and the number of transactions varies. Thus, unethical or fraudulent behavior is harder to conduct or conceal.
UNETHICAL MANAGEMENT BEHAVIOR IN CAPITAL SOURCES AND INVESTING
Source of capital processes and investment processes, described in the early part of this chapter, present important sources and uses of capital in an organization. These processes should be undertaken for the overall good of the organization and in an ethically responsible manner. They must be undertaken ethically, and financial reports and other disclosures must be complete and accurate. Unfortunately, such processes can be misused or abused by management. For example, when raising capital, it is imperative that the investors or creditors be fully informed of all relevant information for making investment or credit decisions. Often, management tries to hide negative information when borrowing funds or selling stock. Such a lack of full and complete disclosure is unethical, because it is an attempt to mislead potential investors or creditors.
The following excerpted paragraphs describe a July 2004 lawsuit filed against Krispy Kreme Doughnuts, Inc., alleging that the company misled investors in the sale of its stock:
The Complaint alleged that Krispy Kreme, along with certain of its officers and directors, violated the federal securities laws by issuing a series of materially false and misleading statements to the market. These misstatements have had the effect of artificially inflating the market price of Krispy Kreme's securities.
Specifically, the Complaint alleged that the Company failed to disclose and misrepresented the following material adverse facts which were known to defendants or recklessly disregarded by them: (1) that the Company used aggressive bookkeeping to boost its earnings when it acquired a franchise; (2) that its core businesses were actually underperforming; (3) that it had expanded too quickly, and would shut down factory stores and doughnut shops in an effort to improve productivity.4
It took more than two years for Krispy Kreme to resolve this lawsuit and correct its financial reporting processes. Its negative operating results, however, persisted for nearly six years.
This Real-World example illustrates the fact that management can mislead investors by altering or omitting key data. To conduct stock sales ethically, management should fully and honestly disclose relevant information to investors.
The lawsuit against Krispy Kreme also illustrates that investors depend on data over and above the numbers in financial statements. Certainly, the financial statements should be accurate and complete. But in addition, all footnote disclosures and other disclosures in the annual report should be complete and honest. Likewise, when borrowing funds from a bank or through bonds payable, management should fully disclose all relevant information to creditors. Management should be completely honest in providing information for the financial statements, footnote disclosures, and any related disclosures. Management should avoid misleading creditors about the financial status of the company or its ability to repay any borrowing.
INTERNAL REPORTING OF ETHICAL ISSUES
To manage ongoing operations, management must review many reports. In addition, proper management of operations requires that reports be disseminated to lower-level managers for two important purposes. First, the reports provide feedback to lower-level managers who monitor and control the processes in which they are engaged. Second, these reports are used by upper management to evaluate and reward the performance of lower-level managers.
Top management has an ethical obligation to use financial and other reports to encourage beneficial and ethical behavior. Perhaps it is easier to understand this ethical obligation by looking at how the use of these reports can encourage unethical behavior. There is an old saying: “What gets measured gets done.” So, if top management uses a report such as a division income statement to evaluate and reward division managers, then division managers are motivated to increase profit in their division. A problem may arise when top management places too much emphasis on division profit and does not measure and reward other facets of performance. A heavy emphasis on profitability can lead to unethical behavior, such as manipulating numbers and transactions in order to show a higher profit. The manner in which top management uses reports can set either a proper ethical tone or an improper one.
To set a proper ethical tone, top management should measure several factors of managerial performance without over-emphasizing profitability or cost cutting. Many firms have adopted or are considering a balanced scorecard approach to internal reporting. A balanced scorecard measures several factors balanced among measures focused on four areas: financial, customer, internal processes, and learning and growth. When a firm uses several measures and includes nonfinancial measures, there is less pressure on lower-level managers to focus only on the financial numbers. Such an environment is less likely to encourage unethical behavior.