Ethical and Legal Obligations in Accounting

According to Marshall (2004), “accounting is the process of identifying, measuring, and communicating economic information about an organization for the purpose of making decisions and informed judgements” (p. 3). Specifically, financial accounting “refers to the process that results in the preparation and reporting of financial statements for an entity” (Marshall, McManus, & Viele, p. 5). While many entities prepare their own financial statements, firms can also contract with a public accounting firm or a Certified Public Accountant (CPA) to perform services such as reviewing or compiling statements. (A CPA is a professional designation granted by individual states.) Entities that are publicly traded or complex in nature contract for auditing services. The provider of the auditing service will test the compliance of the entity’s financial reporting against generally accepted accounting principles as issued by the Federal Accounting Standards Board (FASB). The provider will also ensure that the company, if publicly traded, complies with requirements of the Securities and Exchange Commission (SEC) and the regulations of the Public Company Accounting Oversight Board (PCOAB). This paper briefly explains the principles of financial accounting and how the deviation from ethical and legal obligations led to greater government oversight and the need for ethics training of future accounting professionals.

Principles of Financial Accounting

Since 1973, FASB has been the private sector organization designated to establish standards of financial accounting and reporting. Lending authority to its designation is the recognition of the SEC and the American Institute of Certified Public Accounts (AICPA) as the principle issuing entity for financial accounting principles in the United States. The SEC has statutory authority over setting standards in the public sector; however, according to the FASB website, the SEC relies on the private sector for this function “to the extent that the private sector demonstrates ability to fulfill the responsibility in the public interest” (FACTSaboutFASB, 2005, 2).

Current generally accepted accounting principles (GAAP) and auditing standards require that the financial statements of an entity show the following for the reporting period: financial position at the end of the period (balance sheet), earnings for the period (income statement), cash flows during the period (statement of cash flows), and investments by and distributions to owners during the period (statement of changes in owners’ equity) (Marshall, McManus, & Viele). A central concept is the accounting equation, in which assets equals liabilities plus owners’ equity, which is presented on the balance sheet. Basic principles in recording transactions (which provide the basis for preparing the income statement) are revenue recognition, which occurs at the time of a sale, and the matching principle, whereby the revenue is matched to any corresponding expense that was incurred to produce the revenue. While these concepts and principles and others like them appear simplistic, the applications in complex financial transactions are not universal. “Different accountants may reach different but often equally legitimate conclusions about how to account for a particular transaction or event” because the generally accepted principles of accounting are broad (Marshall, McManus, & Viele, p. 9). Paramount to the preparation of the financial statements is that companies’ financial positions be truthfully reported.

Obligations in accounting

Criticism has been leveled at the United States system of rules-based accounting as determined by standards issued by FASB and its predecessors. The International Accounting Standards and other countries favor principles-based accounting, which provide general guidance or concepts. The correct application of either system, however, depends upon the ethical behavior of the auditors. According to evidence cited by Ng (2004),

One of the main problems with Enron was the myriad complex transactions. These transactions enabled Enron to hide billions of dollars in debt in non-consolidated subsidiaries. Critics argue that use of principles-based standards would not have allowed these transactions to have remained off of Enron’s balance sheet, as the economic substance was that Enron was liable for the debt. But the AICPA Code of Professional Conduct, Rule 203, states that if following an accounting standard results in the financial statements being misleading, proper accounting treatment is to account for a transaction in a way that does not make the financial statements misleading. This is confirmed by several cases, most notably U.S. v. Simon (1969). In this Second Circuit case, Judge Friendly found that literal compliance with GAAP did not preclude auditors from