Faust and Mccabe Case: Ethical Issues

Deb Faust has a problem. She is the financial vice-president, and when classifying first-time securities in the portfolio, she realized she could increase her net income for next year by only including the trading securities that have increased in value. She realized she could also classify the securities that have decreased in value as long-term non-trading securities, ensuring her 2014 net income would not be affected. Her problem lies with her controller, Jan McCabe, who disagrees with her. McCabe wants to do the complete opposite, arguing that the company is having a good earnings year, and by recognizing the losses now, it will help smooth income for next year. In future years, in case of a not profitable year, the company will have built-in gains.

Ethical Concerns in the Faust and McCabe Case

Marketable securities held by a company are reported in the financial statements, but how the company classifies and records these depends on how long the company intends to hold them. Marketable securities can be classified as trading or non-trading, available to sell, or held till maturity. How the company reports these will change the market price of the securities and can affect financial statements. Securities are recorded in the balance sheet at their fair value; however, if there is a change in the fair value, then that change is recognized as a gain or loss.

By classifying the securities in their preferred way, both Faust and McCabe will affect the net income. If they classify the gains as trading securities, it will cause that to show as a gain on the income statement, just as classifying the losses as non-trading securities will defer the losses until next year. This raises a significant ethical issue, as it involves manipulating financial data to present a potentially misleading picture of the company's financial health.

By proposing these different scenarios, each employee is acting unethically. Neither of these proposals is in accordance with the International Financial Reporting Standards (IFRS). The IFRS uses a financial reporting framework to determine the measurement, recognition, presentation, and disclosure of all material items appearing in the financial statement. By manipulating the securities reporting, this is not an accurate presentation of the financial statement. Not only does this inaccuracy affect employees, it is also going to affect the company’s officers, directors, shareholders, and any potential investors that may see this financial statement and believe it is an accurate presentation of the company’s net income. This can also affect potential auditors, who will most likely find this misstatement. According to Ball (2006), misrepresenting financial information can lead to significant consequences for the company and its stakeholders.

Faust and McCabe can certainly address the issue of selling the non-gaining securities with management and be sure they are aware of the potential issues with how they will be classified. These securities can be sold, and this would not be unethical. Engaging in open communication with management could lead to a more transparent and ethical resolution.

Faust and McCabe should take the steps in the ethical decision-making model and think through their ethical dilemma. They can start by addressing what legal issues will arise if they list the securities as they propose. If they evaluate the consequences of their decision by listing the possible outcomes, they could have a better picture of what could happen if they list the securities incorrectly. They also need to consider the other stakeholders in this decision and how they will be affected. They also need to consider their professional obligations with this proposed course of action.

Both Faust and McCabe are demonstrating a lack of professional judgment in this case. They believe they are doing the best thing for the company, but in fact, this could turn into a very harmful situation for everyone. At their core, they believe this is ethical, but by engaging in a poor accounting practice that will misstate a financial statement, they are indeed acting unethically. Ethical decision-making models, as discussed by Trevino and Nelson (2016), emphasize the importance of considering the broader impact of decisions on all stakeholders.

Conclusion

This quote by former SEC chair Arthur Levitt from “The Numbers Game” links the practice of “earnings management” to an excessive zeal to project smoother earnings from year to year that casts a pall over the quality of the underlying numbers. Levitt identifies the cause as a “culture of gamesmanship” in business rooted in the emphasis on achieving short-term results, such as meeting or exceeding financial analysts' earnings expectations. While there is a well-established concept in corporate finance that business decisions should be based on maximizing the wealth of shareholders, this concept could encourage unethical business behavior. Faust and McCabe may feel they are best serving the shareholders and the company by manipulating the securities, but in the end, this will not help the company and could possibly result in auditor findings and potential fines and penalties.

References

• Ball, R. (2006). International Financial Reporting Standards (IFRS): pros and cons for investors. Accounting and Business Research, 36(sup1), 5-27.
• Trevino, L. K., & Nelson, K. A. (2016). Managing Business Ethics: Straight Talk About How to Do It Right. Wiley.