AP® Business with Personal Finance review sheet from Aim for Five (aimforfive.com/business-finance/units/3/3-9)
Unit 3 · Topic 3.9
3.9 Ethics and Financial Reporting
When people handle large amounts of money, or face pressure to make results look good, some are tempted to cheat. This topic covers the main kinds of financial wrongdoing, why it happens, and the laws, professional codes and internal controls that prevent it.
Key terms
- embezzlement
- fraud
- tax evasion
- independent audit
- professional code of ethics
- internal controls
Kinds of unethical financial behavior
- Embezzlement: stealing money you were trusted to handle, like a bookkeeper moving company funds into a personal account.
- Misuse of funds: spending money on purposes it wasn't meant for, like using company money for a personal vacation.
- Tax evasion: illegally hiding income or inventing expenses to pay less tax. (Legally lowering taxes, such as with allowed deductions, is tax avoidance, which is legal.)
- Bribery: offering money or favors to influence someone's decision.
- Lack of transparency: hiding information stakeholders have a right to know.
- Fraud: deceiving people for gain, including falsifying financial statements.
Why it happens
Easy access to a lot of cash creates temptation. Someone who handles deposits alone, with no one checking, may think they can take money unnoticed.
Businesses can also be tempted to make their finances look different from reality. Looking better than it is can push up the stock price or win better loan terms. Looking worse than it is to the government can cut its taxes. Both are deceptive.
Laws and regulation
Almost every country outlaws embezzlement, bribery, fraud, tax evasion and misuse of funds, but the exact laws and punishments differ from place to place. In the U.S., publicly held corporations must have their financial records audited every year by independent accounting firms, outside accountants who check that the statements are accurate. Financial market rules, enforced by the Securities and Exchange Commission (SEC), aim to make sure investors get accurate information and are protected from fraud.
Who gets hurt, and how rules changed
Financial wrongdoing hurts many stakeholders. Investors buy shares at prices based on false numbers, lenders make loans a business can't repay, employees can lose jobs and retirement savings when the truth comes out, and the public loses trust in markets.
Big scandals have led to tougher laws. After the energy company Enron collapsed in 2001 following years of hidden debts and misleading accounting, Congress passed the Sarbanes-Oxley Act of 2002. It made top executives personally certify their company's financial reports, required stronger internal controls and created a board to oversee the firms that audit public companies.
Professional codes and internal controls
Professional organizations for accountants and financial managers have ethics codes for their members. These stress honesty, integrity, transparency, objectivity (staying unbiased) and confidentiality (protecting private information).
Businesses also build their own internal controls: codes of conduct, internal audit requirements and cash-handling rules. A common rule is splitting duties so that no single person both collects cash and records it; two people would have to cooperate to steal, which makes theft much harder to hide.
Worked examples
Try each one yourself first, then open the solution.
- Example 1
Spotting the risk and the fix
At a small chain of car washes, one manager collects each day's cash, counts it, makes the bank deposit and records the amount in the books. Explain the ethical risk and recommend one internal control.
Show the solutionHide the solution
- Step 1: Identify the incentive and opportunity: one person controls the cash from start to finish, with no one checking.
- Step 2: Name the risk: embezzlement. The manager could record a lower amount than collected and keep the difference.
- Step 3: Recommend a control: separate duties. One person counts and records the cash, and a different person makes the deposit and matches it to the bank statement. Surprise audits add more protection.
Answer: The setup invites embezzlement because one person handles and records all the cash. Splitting cash counting, recording and depositing among different people, plus regular checks, makes theft much harder.
Common mistakes
- Calling all tax reduction illegal. Using allowed deductions is legal; hiding income is tax evasion.
- Thinking audits are optional for public companies. U.S. law requires publicly held corporations to have yearly independent audits.
- Explaining unethical behavior without naming the incentive or opportunity behind it.
On the exam
- Expect cases asking which practice (embezzlement, fraud, tax evasion) is described, or which control would best prevent it.
- When asked why someone might act unethically, point to the specific incentive, such as pressure to meet targets or raise the stock price, and the opportunity, such as unchecked access to cash.
Connected topics
Videos
Check yourself: 3.9 Ethics and Financial Reporting
4 questions on 3.9 Ethics and Financial Reporting. Pick an answer to see if you got it, and why.
At Halverson Supply, a publicly traded corporation, one clerk counts the daily cash receipts, records them and takes them to the bank. Over two years, the clerk secretly kept $38,000 for personal use.
Separately, Halverson's chief financial officer (CFO) is about to apply for a large bank loan. The CFO suggests recording next year's expected sales as this year's revenue so that profits look higher.
Hypothetical scenario
The clerk's actions are an example of
Which internal control would most likely have prevented the clerk's theft?
Which best explains why the CFO might want to misstate revenue?
Which requirement makes the CFO's plan most likely to be caught?
0 of 4 answered