Bell Manufacturing, Inc. is a publicly traded company that produces consumer goods for sale, primarily to wholesalers. The company hired your accounting firm, Hogue & Company, more than three years ago under both auditing and consulting engagements to assist with its initial public offering of common stock under the 1933 Securities Act. Hogue & Company is among the 12 largest accounting firms in the United States. It has developed a respectable reputation regarding its ability to help growing companies go public. You are currently an audit manager for Hogue & Company, having been promoted to this position from senior auditor in the last year, due in large part to your successful handling of the Bell Manufacturing account.

You have just returned from lunch with Jay Hoffman, the new chief financial officer (CFO) for Bell Manufacturing, Inc. The purpose of the meeting was to congratulate Hoffman on his recent promotion. You have known Hoffman since you were assigned to this engagement, during which time he has progressed from accounting manager to chief accountant and now to his current position. When you expressed how pleased you were about his promotion, Hoffman explained how proud he was of the accomplishments he has achieved since entering the country as an illegal alien. He then told you that he entered the U.S. illegally because, at the time, that was the only way he could get into this country. He was quick to explain that he has been a U.S. citizen for almost three years and asked that you keep this in confidence.

In connection with your audit of executive payroll, you pulled Hoffmans personnel file, along with those of all senior executives of Bell. After the lunch meeting with Hoffman, you reviewed the contents of his personnel file. As required by federal law, a Form I-9, Employment Eligibility Verification, from the U.S. Immigration and Naturalization Service, was included in his personnel record. Hoffman completed and signed the form in 1992 at the commencement of his initial employment with Bell Manufacturing. He checked the box indicating he was a citizen of the United States and signed the form, attesting under the penalty of perjury that he had made no false statements or used false documents in connection with the completion of the form. Hoffmans I-9 Form, along with the official instructions for completion, is presented as Attachment 1.

Since 1986, federal law has required all newly hired employees (citizens and noncitizens) to complete and sign Section 1 of Form I-9. Federal law also establishes that the employer is responsible for ensuring that Section 1 is timely and properly completed. Employers must then complete and sign Section 2 of the form. This process requires employers to examine evidence of employee identity and employment eligibility within three business days of the date employment begins. The employee must present specific acceptable documentation to verify identity and employment eligibility, for example, a U.S. Passport or Certificate of U.S. Citizenship. A complete list of acceptable documentation is provided on page three of Form I-9 (see Attachment 1). To your surprise, Bell Manufacturing never completed Section 2 of Hoffmans form.

AUDIT ENVIRONMENT, PROFESSIONALISM, AND ETHICS

The independent audit of financial statements is an essential part of the proper functioning of the capital markets. Recent high-profile events, however, have led to the erosion of public confidence in the accounting profession and the capital markets system. It is, seemingly, an understatement to say that accountants and accounting practices have been under fire in recent years. For example, in 1998 then-Chairman of the SEC Arthur Levitt delivered a speech, The Numbers Game, referring to widespread abuses of financial reporting that resulted in earnings management (Levitt 1998). Levitt said, This process has evolved over the years into what can best be characterized as a game among market participants. A game that, if not addressed soon, will have adverse consequences for Americas financial reporting system. More recently, questionable financial reporting and the bankruptcies of Enron and WorldCom have forced the accounting profession under a public microscope. The AICPA (2002a) recently released the following statement: Our profession has zero tolerance for CPAs who do not adhere to the rules. A document prepared jointly by the Big 5 accounting firms and the AICPA offers suggested actions that management, auditors, and audit committees can contribute to ensure high-quality financial reporting for the benefit of investors (AICPA 2002b).[1] Included in these suggestions for auditors are the following:

• Understand the stresses on the companys internal control over financial reporting, and how they impact its effectiveness.
• Approach the audit with objectivity and skepticism, notwithstanding prior experiences with or belief in managements integrity.
• Question the unusual and challenge anything that doesnt make sense.
• When faced with a gray area, perform appropriate procedures to test and corroborate managements explanations and representations, and consult with others as needed.

Auditors carry out their responsibilities and perform services in the context of serving the public interest. In this role, CPAs are thought of as professionals. Although professionals have earned a level of respect, the key concept in this context is that professionals also are expected to adhere to a higher level of performance. Therefore, it is helpful to consider how the legal system views CPAs. The New York Court of Appeals, in 1974, defined a profession as having certain distinguishable characteristics including: (1) requirements for formal training and learning, (2) admission to practice by qualifying licensing, (3) a code of ethics beyond that generally established in the marketplace, (4) a system to discipline its members for violation of the code of ethics, and (5) duties of members to conduct themselves honorably.2 At its core, the term professional communicates that the client places an above-normal level of trust on the provider and/or a fiduciary duty exists between the client and the provider. The CPA profession is characterized by each of these traits and is legally considered a profession. Consequently, CPAs are expected to provide competent service characterized by ethical behavior consistent with carrying out fiduciary duties.

Auditors must balance competing interests to perform their public service role. Although a major responsibility is ensuring that financial statements are prepared in accordance with the rules (GAAP), protection of the public interest is paramount. The auditors job has become more difficult as the number of accounting rules and the complexity of these rules has increased in recent years. Although U.S. standard setters are under pressure to promulgate simpler rules that converge with International Accounting Standards (IAS), the changing landscape of simpler rules may not relieve pressures on auditors. These pressures are best mitigated by the consistent application of ethical decision making. Therefore, understanding the role of ethics is essential in the development of an accounting professional expected to exercise professional judgment in this dynamic environment.

Rules-Based Profession

Accounting has long been a rules-based profession. Future CPAs begin their professional careers studying detailed rules such as GAAP, GAAS, and the Internal Revenue Code. The AICPA requires candidates to demonstrate competency in these areas and others during the CPA exam, which is a prerequisite to the licensing of accountants as CPAs.3 Rules are intended to improve financial reporting in order to help protect the public interest. However, in todays environment, is mastery of and conformity with the rules sufficient for the practice of accounting?

Pincus (2000) argues that a rules-based system is inherently suboptimal. Ironically, she attributes suboptimization to the tendency of human decision makers to act as if optimization of a rules-based system were possible. Human decision makers tend to treat prescriptive rules as definitional that is, they tend to treat rules as determining how a game is played, rather than as guidelines for right behavior. They tend to become rule-bound, rather than rule-guided (Pincus 2000, 247).

Consistent with Levitts (1998) description of The Numbers Game, Pincus explains that a rules-based system can degenerate into a high-cost game of ex post justification of decisions. The sources of these costs can be dichotomized into (1) an absence of rule problem, and (2) a presence of rule problem (Pincus 2000, 247).

An absence of rule problem can occur when rules do not address a particular transaction or event. As a result, decision makers may see an opportunity for creative accounting. That is, as long as their position is not expressly prohibited by a rule, why wouldnt it be acceptable? As Pincus describes, Since no rule-based system can hope to specify all the factual predicates, a vicious cycle of absence, abuse of absence, and rule making is the result (Pincus 2000, 248).

Unfortunately, problems can also arise when rules are present. According to Pincus (2000), A presence of rule problem exists when decision makers follow the letter of the rules, but ignore their spirit. In this context, detailed rules can lead to degenerative game-playing behavior.

Principles-Based Accounting Standards

The FASB is currently under pressure to shift from the traditional model of rules-based standards to principles-based standards. R. K. Herdman (2002), Chief Accountant, U.S. Securities and Exchange Commission, expresses concerns about the timeliness, transparency, and complexity of U.S. GAAP. His criticisms described the standard-setting process as too slow, too complex, and rules-based that focuses on a check-the-box mentality that inhibits transparency. Herdmans (2002) proposed corrective actions include meaningful SEC participation in setting the FASBs agenda, SEC review of adopted standards, and to ensure that the FASB promulgates principle-based standards, which adapt faster to changing business environment and emphasize overall accuracy and completeness. We believe that FASBs standards, at least going forward, should evolve to become general and principle-based, instead of encyclopedic and rule-based, standards. Herdman goes on to say, we believe that principle-based standards in general are better suited to the sort of rapidly changing financial landscape in which companies operate. In addition, this approach to standard setting allows the standards to be issued more quickly, which is increasingly important.

Katherine Schipper (2002), a board member of the FASB, responded to the criticisms in a

presentation to the American Accounting Association on August 16, 2002. Schipper discusses the criteria used by the FASB to make decisions. She refers to the FASBs Conceptual Framework (FASB 1978, 1980a, 1980b, 1984, 1985, 2000) (Figure 1) as augmented by Jonas and Blanchet (2000, 359). As Figure 1 depicts, standards must first meet the test of decision usefulness. Other criteria include relevance, reliability, comparability, consistency, and clarity. She cautions, however, that if future, principles-based standards contain less implementation detail, there will be required shifts in behavior from all involved parties: FASB, other standard-setting bodies, preparers, auditors, SEC (Schipper 2002). She maintains that the FASB must articulate, within each standard, the objective (what is intended) within the context of the FASBs Conceptual Framework. The behavior shifts for preparers and auditors are central. According to Schipper (2002), this requires explicit expectations about the exercise of professional judgment in meeting the stated objective of the standard.

Robert Herz, recently appointed Chairman of the FASB, is supportive of principles-based accounting standards. In an August 2002 interview with the Business Week online associate editor (Stone 2002), Herz responded to a series of questions about principles-based standards.

When asked to explain the concept of principles-based accounting standards, he said, A principles-based system is one where the accounting standard simply lays out objectives of good reporting in an area. It may include some rules, based on the objectives, but it doesnt try to answer every question or provide a rule for every situation. So the standard would be more like 10-12 pages than 200 pages. We would tell people that, if you cant see a particular rule to fit your situation, go back to the main objective or principle. There are no exceptions to the basic principle. It would be very different than standards now. This is something the Sarbanes-Oxley legislation requires the SEC to studyIt is aimed at eliminating the vast array of exceptions we have in existing standards. Right nowrules are issued by four different bodies and we have thousands of pages of rules. The problem with that, in my view, is that for those who want to comply with the rules, they are not always sure of everything they need to look at. One rule may contradict another. Those looking to get around the rulecan use legalistic approaches to try and do it. So the current system has downsides for those who want to comply with rules and benefits for those who dont want to. When asked why the idea of principles-based standards is controversial, Herz replied, The flipside is it requires the exercise of good judgment by both companies and auditors. Those who dont like a principles-based approach say, I dont trust people to do that. They think people need rules to follow or they will find a way to make an objective fit almost any situation.

1. Address each of the following from the context of the impact on your financial statement audit work. Support each position by researching and discussing guidance provided by GAAS (cite specific sections of GAAS and how they apply).

a. Does the illegal act increase the potential for fraud in the financial statements?

b. Assess the impact on the audit of the internal controls in the human resources department.