Unit 3 · Topic 3.9 · about 25 minutes
Ethics and Financial Reporting
Explain what tempts people to misuse a business's money or misreport its finances, and how laws, independent audits, ethics codes and a business's own safeguards push back.
Predict first
The owner of a struggling landscaping company is filling out two documents this month: a loan application for his bank and the company's tax return. If he were willing to lie, which way would he be tempted to shade the company's profit on each one?
What crosses the line
Some unethical practices in finance are about taking money. Others are about hiding or faking information. Fraud is the broadest of them, and it can include falsifying the numbers on financial statements.
| Practice | What it means | An example |
|---|---|---|
| Misuse of funds | Spending money on something other than what it was raised or approved for | An owner spends a loan meant for new ovens on a family vacation |
| Tax evasion | Illegally paying less tax than is owed | A restaurant leaves its cash sales off its tax return |
| Embezzlement | Taking money you were trusted to manage and using it for yourself | A bookkeeper moves company money into her own bank account |
| Bribery | Giving or accepting money or favors to sway someone's decision | A supplier pays a buyer $2,000 to keep choosing its products |
| Lack of transparency | Hiding information that stakeholders need to make decisions | An owner refuses to show a co-owner the business's bank statements |
| Fraud | Deceiving people for financial gain, including falsifying financial statements | A company records sales that never happened to look more profitable |
Why people are tempted
Access to cash. Anyone who handles large sums of a business's money, such as a cashier, a bookkeeper or a finance manager, is in a position to embezzle it, misuse it or falsify the records for personal gain. The danger is greatest when the same person handles the money and keeps the records, because that person can also hide what is missing.
A payoff from misleading people. A business or its financial managers may be able to influence its stock price, get better terms on a loan, or avoid taxes by portraying its financial situation as better or worse than it really is. Better to investors and lenders, worse to the government: the direction depends on who is being misled. A manager whose bonus depends on hitting a profit target feels the same pull for personal reasons.
Sort it
Tap each situation, then tap the practice it describes.
Embezzlement
Tax evasion
Bribery
Falsifying financial statements
What keeps financial reporting honest
Laws. Misusing funds, tax evasion, embezzlement, bribery and fraud are illegal in most countries, though the laws and the punishments vary from country to country.
Independent audits. A publicly held corporation is one whose shares are bought and sold by the public, often on a stock exchange. Under U.S. law, publicly held corporations must submit their financial records every year for auditing by an independent accounting firm. Independent means the auditors do not work for the company and have no stake in how its numbers look. Financial market regulations go further. They are designed so that investors have access to accurate information and are protected from fraud.
Professional ethics codes. Professional organizations for accountants and financial managers maintain ethics codes for their members. The codes emphasize honesty, integrity, transparency, objectivity and confidentiality. Objectivity means not letting personal interest bend a judgment about the numbers. Confidentiality means not sharing a client's or employer's private financial information.
Internal mechanisms. Many businesses build their own safeguards to prevent unethical behavior, such as codes of conduct, audit requirements and cash-handling processes.
Worked exampleFinding the weak spot
At Fresh Field Market, a small grocery store, one manager counts the cash at closing, takes it to the bank and enters the day's sales in the books. The owner looks only at the monthly totals. What makes this risky, and what should the owner change?
Find the opportunity. The manager handles large sums of cash and also keeps the records that would show if any went missing. She could take $300 from a day's cash, record that much less in sales, and the books would still look normal.
Name what it would be. Taking money she is trusted to manage is embezzlement. Changing the sales records to cover it falsifies the store's financial information.
Split the jobs. Two employees count the cash together and both sign the count, and a different person records the day's sales from the register's own report. A theft would now take two people working together, and it would still leave a mismatch between the register report and the deposit.
Add checks and rules. An audit requirement, such as the owner comparing each week's bank deposits with the register reports, catches a mismatch early. A written code of conduct makes the rules, and the consequences of breaking them, clear to every employee.
The weak spot is one person controlling both the cash and the records. A cash-handling process that splits those jobs, an audit requirement and a code of conduct are the internal mechanisms that close it.
Check your understanding
In which situation does an employee have the greatest opportunity to embezzle money without being caught quickly?
A company is applying for a large bank loan. Why might a dishonest financial manager overstate its profit on the statements given to the bank?
Under U.S. law, what must a publicly held corporation do with its financial records every year?
Which of these is an internal mechanism that a business creates to prevent unethical behavior?
A company's managers learn that its largest customer, the source of 40% of its sales, will stop buying next month. They leave this out of their report to shareholders, and every number in the report is accurate. Which unethical practice does this describe?
Course alignment, for teachers
AP Business with Personal Finance topic 3.9, Unit 3: Personal Saving and Borrowing / Business Finance and Accounting.