Ethical dilemma : Billing for Ernest's cover-up

Scenario

You are an audit senior manager for a manufacturing client in the FTSE 350 where your firm's working relationships with theGroup's long-standing Finance Director, Ernest, are notoriously 'difficult'.

Some weeks ago,Neil,theengagement partner, asked you to 'sort out' the accountancy and financial statements of a small private company that had been set up a few years ago to make 'artistic' films. This company had been persistently loss making and its one film, which had taken significantly longer to release than expected, had flopped at the box-office. During the leisurely production process, significant sums seemed to have been spent on hotels and restaurants.

The shareholders and directors of the company are a young film director and the nubile actress who starred in the film. They are 'resting' and have told you that the company too is now dormant and will be wound up. There are just enough funds to cover the costs of this and of residual bills. Apart from a few small grants, the majority of the finance had been by way of loans that will not now be repaid.

You were very surprised to discover that the source of all these loans had beenErnest.He had also given personal guarantees that all trade creditors will be paid. As requested byNeil, you have worked closely with a colleague in your firm's tax department to progress the efficient submission to HMRC of tax computations for the film company.

Alongside this, some advice was given personally toErneston the idiosyncrasies of tax and film finance. Apparently, he had previously always dealt with his own tax affairs.

At the start of the assignment two separate charge codes, Accountancy and Tax were set up for the film company. Time costs for the work, at your firm's normal rates, have amounted to20,000 for dealing with the Accountancy and 4,000 for the Tax.Neilhas now sent you instructions relating to monthly billings.

These include:

• Afee note of 2,000to be issued to the film companywith2,000 of accountancy time costs written off against it.The Accountancy code is then to be closed.
• Theresidual 18,000 is to be transferred to a 'Special Work' client account of the Group. This already has in it the time costs of12,000 for an investigation into a stock discrepancy carried out earlier in the year. The partner tells you that the4,000 of tax time will also be transferred across.
• The raising of two further fee notes, one for27,500 addressed to the Group and one for500 to be sent to Ernest personallyat his home address. In all cases the fee notes' descriptions are to be limited to "agreed professional fees".

You have askedNeilin person to confirm these arrangements. Clearly very amused,Neil explained that Ernesthad funded the film company over the years on the persuasion of the young actress.Ernest now accepts his investment was seriously flawed and that the loans will never be re-paid.

He is keen, to the extent legally possible, to minimise further his personal expenditure while gaining any tax advantages available. Moreover, the situation is, for himself, one of considerable potential embarrassment.

He wants the maximum discretion. He is now very grateful to the firm for the work done and, after some remarkably swift negotiation, has approved the three billings represented byNeil's instructions.Ernest accepts one further note of fee will be necessary for completing the tax work.

This will go to the film company and, as with all the other residual creditors, Ernest will ensure personally that it is paid.

Neil commented that the total billing of 30,000 against incurred costs of 36,000, at 83%, was not as good a recovery as he would have hoped, or might even have negotiated. Yet, this has been his favourite assignment of the summer. He added:

I could probably have gone for much higher margins. But I think that it will prove better in the long-term not to have been greedy. Of course, I know Ernest's gratitude won't linger forever.

Even so, I think he may be just that bit more co-operative and less aggressive in future. When he reflects that we haven't taken advantage of him and thinks carefully about what we now know, I sense that we will be able to count on his loyalty right through to his retirement! And given how much the old fool has lost on that actress, he'll need to go on working for a good few years yet!

When you now ask Neil about the ethics of transferring the time costs between clients that have no formal relationship and the apparent subsidy to Ernest personally, he replies:

OK, I know that I appear to be charging 27,500 to the Group for an assignment that incurred costs of only 12,000. But the Audit Committee delegated to Ernest the authority to agree fee notes of up to 30,000 for that stock investigation. This time it came in at less.

Because of Ernest's attitudes in the past we have not been able to recover as much as we should for good work. It's swings and roundabouts.

As for the film company job, I had no real clue from Ernest when we went into it just how heavily he was involved. He said it was primarily a referral to help friends where he has no official, company status.

Overall, I haven't even pressed for full recovery. No one can tell me the recovery that I have to make on any individual fee note. If I choose, say, zero fee for one piece of work, only 10% for another but 230% for a third, that is my commercial decision. If this gives you a real problem, just don't transfer time costs between client codes and then don't make any explicit connections.

But it will simply be less effort to report one recovery of 100% and one of 82% for our billing department, rather than explaining the detail of 10% here and 200% plus there. The fee income is a done deal; the end result is the same; stand by for a new, more co-operative Ernest!"

What do you do now?

Scenario Analysis

What are the readily identifiable ethical issues for your decision?

1) For youpersonally

• Do you consider yourself compromised ethically by the initial instructions over billing, such that you need to take alternative action?
• If so what action?

For theCA firm

• Has an unacceptable conflict of interest arisen from doing, essentially, personal work for a client's FD, even though formally he is neither a shareholder nor officer of the film company?
• How do you deal effectively with the sensitivities of billing for professional work and the difficulties of valuing and gaining a perceived 'fair' recovery from a client where there is a determination by the client to haggle over everything?
• Can the outcome - while imperfect be justified on the grounds that the audit firm will be more secure and be able to take a 'tougher' line as auditors in future?
• Or, is the solution, (of apparent exploitation of a lack of transparency in the billing process) symptomatic of an overall lack of professional integrity in the relationships?

Note:at the time when this occurred there were no formal constraints on providing a personal tax service to, and billing personally, an officer of a corporate client.

However, this regulatory detail does not alter the underlying issues. For example, in the Scenario described, the token 500 bill for tax and film finance destined for Ernest personally could have been ignored without material financial implications.

This charge (or for some other amount) could have been incorporated into the bill sent to the film company for Ernest to settle in full along with residual creditors.

2) What fundamental ethical principles for accountants are most applicable and is there an apparent conflict between them?

Integrity

• Do billing arrangements agreed between Neil and Ernest represent honesty, full truthfulness and fairness?

Objectivity

• Has the tense relationship with Ernest over fees been replaced with another, if covert, set of dynamics for achieving pragmatic completion of mutual tasks in relation to the company?

Confidentiality

• could the Audit Committee justifiably consider that it should have been informed of the 'new' assignment, once the details of Ernest's involvement were known?
• By contrast could Ernest justifiably consider that any initiative now by the audit firm to refer to his (indirect) relationship with the film company would be a breach of other expectations of confidentiality?