In 20X0 Arnold Diaz is a bright, upcoming audit manager in the Adelaide office of a national accounting firm. He is an excellent technician and a real 'people person'. Arnold is also able to bring new business into the firm as a result of his contacts in the Filipino business community.

Arnold is assigned a new client in 20X1, XYZ Securities Ltd, an unlisted broker-dealer in the secondary market for government securities. Neither Arnold nor anyone else in the Adelaide office has brokerdealer audit experience. However, Arnold's firm has audit aids for the industry, which Arnold uses to get started.

Arnold is promoted to partner in 20X1. Although this is a great step forward for him (he was a new staff assistant nine years earlier), Arnold is under a great deal of pressure. On making partner, he is required to contribute capital to the firm. He also feels he must maintain a special image with his firm and his clients, and within the Filipino community. To accomplish this, Arnold maintains an impressive wardrobe, buys a new BMW and a small speedboat, and trades up to a nicer house. He entertains freely. Arnold finances much of this higher living with credit cards. He has six cards-American Express, Visa and MasterCard-and runs up a balance of about $40 000.

After the audit is completed and before the 20X2 audit begins, Arnold contacts Jack Oakes, the chief financial officer of XYZ Securities, with a question. Arnold has noticed an anomaly in the financial statements that he can't understand and asks Oakes for an explanation. Oakes's reply is as follows:

Arnold, the 20X1 financial statements were materially misstated and you guys just blew it. I thought you might realise this and call me, so here's my advice to you. Keep your mouth shut. We'll make up the loss we covered up last year, this year, and nobody will ever know the difference. If you blow the whistle on us, your firm will know you screwed up and your career as the star in the office will be down the tubes.

Arnold says he'll think about this and get back to Oakes the next day. When Arnold calls Oakes, he has decided to go along with him. After all, it would only be a 'shift' of a loss between two adjacent years. XYZ is a private company and no one would be hurt or know the difference. In reality, he is the only person exposed to harm in this situation, and he has to protect himself, doesn't he?

When Arnold goes to XYZ to plan for the 20X2 audit, he asks Oakes how things are going and Oakes assures him they are fine. Arnold then says to Oakes:

Jack, you guys are in the money business; maybe you can give me some advice. I've run up some debts and I need to refinance them. How should I go about it?

After some discussion, Oakes volunteers a 'plan'. Oakes will give Arnold a cheque for $15 000. XYZ will request its bank to put $60 000 in an account in Arnold's name and guarantee the loan security on it. Arnold will pay back the $15 000 and have $45 000 of refinancing. Arnold thinks the plan is great and obtains Oakes's cheque for $15 000.

Between 20X2 and 20X4, three things happen. First, Arnold incurs more debts and goes back to the well at XYZ. By the end of 20X4 he has 'borrowed' a total of $125 000. Second, the company continues to lose money in various 'off-the-books' investment schemes. These losses are covered up by falsifying the results of normal operations. Third, the audit team, under Arnold's leadership, 'fails to find' the irregularities and issues unqualified opinions.

In 20X3, Oakes has a tax audit of his personal 20X2 return. He asks Arnold's firm to handle it and the job is assigned to Bob Smith, a tax manager. In reviewing Oakes's records, Smith finds a $15 000 cheque payable from Oakes to Diaz. Smith asks to see Diaz and asks about the cheque. Arnold breaks down and confides in Smith about his problems. Smith responds by saying:

Don't worry, Arnold, I understand. And, believe me, I'll never tell a soul.

In 20X5, XYZ's continuing losses make it unable to deliver non-existent securities when requested by a customer. This leads to an investigation and liquidation by XYZ. Losses total in the millions. Arnold's firm is held liable and Arnold is found guilty of conspiracy to defraud.

REQUIRED

a. Try to put yourself in Arnold's shoes. What would you have done (be honest with yourself) when told of the material misstatement in mid-20X2?

b. What do you think of Bob Smith's actions to help Arnold?

c. Where does one draw the line between ethical and unethical behaviour?