CHAPTER 15

Management Control-Related
Ethical Issues

Managers involved in designing and using management control systems (MCSs) should have a
basic understanding of ethics. Ethics is the field of study that is used to prescribe morally accept-
able behavior. It provides methods to distinguish between “right” and “wrong” and to system-
atically determine the rules that provide guidance as to how individuals and groups of
individuals should behave. Its systematic nature goes beyond what even thoughtful people do
in making sense of their own and others’ moral experiences.
Ethics is important to understand for managers involved with MCSs. Ethical principles can
provide a useful guide for defining how employees should behave. Further, employees’ ethics
are an important component of personnel and cultural controls (which we discussed in
Chapter 3). If good ethics can be encouraged in an organization, they can substitute for, or aug-
ment, actions controls (Chapter 3) or results controls (Chapter 2). In the aggregate, the ethical
principles that employees follow help define the organization’s core values and, hence, its cor-
porate culture and work climate.
Ethics is a difficult subject for many managers to understand. Many managers’ basic disci-
pline training is in economics or business.1 Two common assumptions in economics are that
rational people should act to maximize their own self-interest and that the primary purpose of
employees in for-profit organizations is to maximize shareholder value.2 Ethics, however, pro-
vides alternative assumptions about how people should, and do, behave. It assumes that ethical
individuals must consider the impact of their actions on other stakeholders – those affected by
their actions – including employees, customers, suppliers, local communities, and other users of
shared resources, such as people and animals, that might be affected by corporate use of land,
water, and air.
Ethical behavior and value-maximizing behavior are not equivalent. While the commonly
cited aphorism “good ethics is good business” is usually true, it is not always true. Good ethics
do not always “pay off ” for the individuals or organizations involved, and definitely not always
in the short term. Ethical individuals sometimes must take actions that are not in their own self-
interest, and/or not in their organization’s owners’ best interest, due to some legitimate inter-
ests of other stakeholders. Employees must be accountable to these non-ownership stakeholders
as well, and no group, not even owners, automatically has priority over the other stakeholders.
Indeed, it is the struggles between being selfish and doing “what is right” that provides the most
interesting and important ethical issues that must be considered.
It would be comforting to think that people will be rewarded, at least in the long term, for
doing the right things. But that does not always happen. Many employees who do what is right
sometimes earn lower bonuses, are passed over for promotions, or are even fired. Miscarriages
of justice like these have led to the passing of laws (such as the whistle-blower protection

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provisions in the Sarbanes-Oxley Act) to protect the rights of employees who were doing the
right things. Conversely, employees who act unethically often benefit from their unethical
actions. Sometimes they are not caught, and sometimes their bosses are complicit in the uneth-
ical practices, look the other way, pressure them, or even reward them for doing the wrong
things.3 The following quote illustrates some form of this:

Whenever you see a company where the CEO takes an active, ongoing interest in how
transactions are accounted for, that’s a huge red flag [for aggressive accounting]. Chief
executives need to run the business, they don’t need to run the accounting.4

The potential for personal sacrifice while acting ethically is reflected in many codes of pro-
fessional conduct. The preamble of the Code of Professional Conduct of the American Institute
of Certified Public Accountants (AICPA) states, “The Principles call for an unswerving commit-
ment to honorable behavior, even at the sacrifice of personal advantage.”5 But when are the
ethical principles so important that they dominate natural self-interest concerns? This is a core
ethical question.
This chapter provides an introduction to the complex subject of ethics. It discusses how to
conduct good ethical analyses and why they are important, the reasons why people behave
unethically, and where MCS-related ethical issues are commonly found. The chapter concludes
with some suggestions for encouraging ethical behavior in organizations.

Good ethical analyses and their importance

Unethical behaviors are costly to individuals, organizations, markets, and societies. They create
needs for extra laws and standards from governments and regulatory agencies, and extra rules,
reviews, or supervision within organizations. These extra enforcement mechanisms are incom-
plete, imperfect, and expensive, and have the typical drawbacks of rigid action controls. Good
ethics is the glue that holds organizations and societies together. In the words of Christine
Lagarde, managing director at the International Monetary Fund (IMF):

Regulation alone cannot solve the problem. Whether something is right or wrong cannot
be simply reduced to whether or not it is permissible under the law. What is needed is a
culture that induces bankers to do the right thing, even if nobody is watching.6

Lapses in ethics are often precursors of more serious problems, such as fraud. Mark Carney,
governor of the Bank of England, refers to this more generally as “ethical drift”:

The traders who rigged LIBOR worked in a clubby, laddish atmosphere, a world removed
from the woolly commitments to good behavior set out in banks’ mission statements.7

An example of ethical drift is “aggressive” financial reporting, which many interpret as less
than ethical but maybe not quite illegal, and which often appears to be one step on a “slippery
slope” that eventually culminates into costly, fraudulent activities. As Warren Buffett, chair-
man of Berkshire Hathaway, put it:

Once a company moves earnings from one period to another, operating shortfalls that
occur thereafter require it to engage in further accounting maneuvers that must be even
more “heroic.” These can turn fudging into fraud.8

Indeed, many of the worst corporate failures had aggressive accounting practices in common
in the years leading up to their eventual ruin.9 And, even if aggressive accounting practices do
not lead to ruin, they can be costly.10 We have given numerous examples throughout this text,

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such as the opening examples in Chapter 1, which prove this point.11 To add another example,
Tesco, the United Kingdom’s biggest supermarket chain, was said to be “consistently aggressive –
Tesco had a more aggressive policy than its peers with regard to revenue recognition, deprecia-
tion and property-profit allocation.”12 In late 2014, Tesco faced the worst crisis in its 95-year
history when it announced it had overstated its expected profits by £250 million, “prompting
the suspension of four senior executives and wiping more than £2 billion off the value of the
supermarket behemoth, bringing its share price to an 11-year low as regulators with the power
to impose unlimited fines hovered.”13
Just as they need good skills in their technical disciplines in order to make good business
judgments, managers need good ethical reasoning skills to make good ethical judgments. Sen-
ior managers themselves should know how to behave so that they can serve as moral exemplars,
or role models, within their organizations. This is the foundation of what is commonly referred
to as tone at the top, which we discussed in Chapter 3.
Top management should also design their MCSs to promote moral points of view and ethical
behaviors. A number of highly specific controls, including some policies and procedures and
elements of measurement and reward systems, stem from ethical analyses. But these controls
need to be supplemented with some other controls that help ensure ethical behaviors in areas
where totally precise organizational prescriptions are impossible, including training sessions,
sets of values, codes of conduct, and credos that help employees identify, appreciate, and assess
ethical issues.14
Second, ethical issues often are addressed with simplistic rules, such as “always tell the
truth,” “do no harm,” or “do unto others as you would have them do unto you.” Such simple,
conscience-based rules work only when the values of the person invoking the rule are shared by
the others who are or might be affected. As a consequence, they rarely provide guidance for
ethical behaviors in specific (management control) situations because people’s values often
vary widely.

Ethical models
The first challenge in adapting ethical thinking to managerial settings is in recognizing the
existence of the ethical issues that do or might exist. The ethics literature includes numerous
normative models of behavior. Almost all of these models recognize that, in a social context,
ethics is about how actions affect the interests of other people. Every ethical issue involves mul-
tiple parties, some of whom benefit while others are harmed, slighted, or put at risk by a par-
ticular action. The characterizations of harm, slight, or risk are made in terms of one or more
ethical principles, rules, or values that are embedded in the various normative models of behav-
ior. The following sections describe briefly four commonly cited ethical models – utilitarianism,
rights and duties, justice/fairness, and virtues.15 Each model has merits, but none is perfect;
each has its own limitations.

Utilitarianism
Using the utilitarianism (or consequentialism) model, the rightness of actions is judged on the
basis of their consequences.16 Adopted by many businesses because of its tradition in econom-
ics, utilitarian-type thinking has been embedded in many public policy decision procedures,
such as welfare economics and cost-benefit analyses. In this model, an action is morally right if
it maximizes the total of good in the world; that is, if it produces at least as much net good (ben-
efits less costs and harms) as any other action that could have been considered. Sometimes this
objective is phrased as the greatest good for the greatest number of people. Utilitarianism does not
mean that the right action is the one that produces the most good for the person performing the
act, but rather the one that produces the most good for all parties affected by the action.

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Utilitarian models have some obvious limitations, however. Quantifying net good is difficult
because the benefits of some actions or decisions, such as job satisfaction, freedom from stress,
or a risky possibility of additional profits at some time in the future, are difficult to measure,
aggregate, and compare across individuals. Further, using utilitarian-type reasoning makes it
easy to sacrifice the welfare of a few individuals for the benefit of others. For example, in a
famous case from the 1970s, Ford Motor Company’s management decided not to do a safety
retrofit of the company’s Pinto subcompact car to prevent the gas tank from rupturing in rear-
end collisions. They used the logic that the expensive retrofit of 11 million Pintos would save
only a maximum of 180 deaths, so it would not be cost effective from a societal point of view.
Nonetheless, some people did die in horrible, fiery accidents.17

Rights and duties

The rights and duties model maintains that every individual has certain moral entitlements by
virtue of their being human. Commonly cited basic rights in most modern societies include the
rights to dignity, respect, and freedom. Some societies also accept that people should have
welfare rights, such as the right to be educated and to have access to healthcare and good hous-
ing. Regardless of what is on the list, every right that an individual has creates a duty for some-
one else to provide, or at least not to interfere. So if an individual is said to have a right to
privacy, then others have a duty not to interfere with that person’s privacy. If top management
has a right to be given informative performance reports, then the managers or employees
reporting to them have the duty to provide those reports. In other words, rights and duties
need to be mutually observed by those participating in the group to which those rights and
duties apply.
The rights and duties model has some significant limitations. It is sometimes difficult to get
agreement as to what rights different individuals or groups of individuals should have. Rights
can proliferate. They can also conflict. Do smokers have the right to smoke, or do others have
the right to be free of second-hand smoke? Does management have a right to receive totally
informative performance reports, or should those reporting to them have the right to retain
some of their private information to themselves in order to, for example, protect themselves
from some risk, such as a potential risk of dismissal?

Justice/fairness
The justice or fairness model maintains that people should be treated the same except when
they are different in relevant ways. Most societies conclude that processes, not necessarily out-
comes, should be fair. Most people are not concerned when an already wealthy person wins a
lottery if the process was fair. Having a fair process, such as in evaluating employee perfor-
mance, depends on such things as impartiality and consistency. This may explain why alleged
pay inequality inside organizations is, unlike the lottery example, not always accepted as fair.
This view is illustrated by opinions such as “trust in business will be damaged by the perception
that an executive ‘elite’ is reaping all the rewards from economic growth,” and “all employees
should share in a company’s success and gaps between those at the top and low and middle
earners cannot just get wider and wider,” suggesting that the pay-setting and/or performance
evaluation and incentive systems and processes are improper.18
Treating people the same except when they are different in relevant ways needs proper cali-
bration. People differ in many ways. Thus, determining which of these differences should be
considered relevant is a core issue that must be addressed in applying the justice/fairness
model. Employees may not be concerned when their compensation packages differ when it
arises from differences in the nature of the job. It is seen as fair for people with jobs that are
more difficult, more stressful, or riskier to be paid commensurately. But some may not deem it
fair for people who have greater needs, such as a single parent, to be paid more than others

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performing like jobs by virtue of being a single parent. They feel such hardship needs should be
taken care of elsewhere, such as through government support programs.
Another limitation of the justice/fairness model is that it is easy to ignore effects on both
aggregate social welfare and specific individuals. Perceived justice for one group may harm
another group. For example, when pharmaceutical companies are ordered to pay large dam-
ages to plaintiffs who allegedly suffered ills even in cases where there is little direct evidence of
the drugs causing those ills, could one submit that justice has been done for the plaintiffs but not
for the companies?

Virtues
A final commonly used model of moral behavior is rooted in virtues. Prominent examples of
virtues are integrity, loyalty, and courage. Individuals with integrity have the intent to do what
is ethically right without regard to self-interest. Integrity has many components, including hon-
esty, fairness, and conscientiousness. Loyalty is faithfulness to one’s allegiances. People have
many loyalties, including to other persons, organizations, religions, professions, and even
causes. When loyalties conflict, their relative strength dictates how the conflict is resolved.
Courage is the strength to stand firm in the face of difficulty or pressure.19
Virtues are often reflected in both professional and corporate lists of values, credos, and
codes of conduct. For example, the Statement of Ethical Professional Practice from the Institute
of Management Accountants (IMA) is organized into four areas of virtue: competence, confi-
dentiality, integrity and credibility.20 The Financial Executives International’s Code of Ethics
also uses virtue concepts as it requires members to conduct their business and personal affairs
with honesty and integrity. 21 Similarly, the document describing the Code of Conduct for
Google (now Alphabet) starts by describing the company’s informal corporate motto – “don’t be
evil” (which was changed to “do the right thing” for Alphabet).22 It then goes on to describe a
number of corporate principles or values. In the area relating to “Serving Our Users,” Google
employees are asked to have their actions guided by the following principles: usefulness (of
products, features, and services), integrity, responsiveness (to users), and taking action.23 Parts
of many corporate codes of conduct define how individuals ought to behave; in other words, in
terms of duties. Virtue theory does not deal directly with duties, although often duties can be
derived quite logically from virtues.
Virtues provide their own intrinsic rewards. Virtuous individuals appreciate, and hence pur-
sue, these rewards. But not all employees in organizations should be taken as virtuous prima
facie, which is why other forms of controls are necessary. As such, publicized sets of virtues can
be a valuable part of an organizational control system. However, action controls, such as poli-
cies and procedures, cannot always be made both specific and complete. This limitation is
reflected in Google’s Code of Conduct:

It’s impossible to spell out every possible ethical scenario we might face. Instead, we rely
on one another’s good judgment to uphold a high standard of integrity for ourselves and
our company. We expect all Googlers to be guided by both the letter and the spirit of this
Code. Sometimes, identifying the right thing to do isn’t an easy call. If you aren’t sure, don’t
be afraid to ask questions of your manager, Legal or Ethics & Compliance.24

Virtues fill in the gaps and provide guidance as to what is the right thing to do. They are an
element of personnel or cultural control.
Virtue-based approaches, however, also have limitations. One problem is that the list of
potential virtues is long. For example, in addition to those mentioned in the codes mentioned
above, one might consider character, generosity, grace, decency, commitment, frugality, inde-
pendence, professionalism, idealism, compassion, responsibility, kindness, respectfulness, and
moderation. Critics of the virtue model argue that it is not obvious which set of virtues should

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be applied in any given setting. In addition, some characteristics considered virtues can actu-
ally impede ethical behavior. Courage, for example, is sometimes essential to commit fraud,
and respect for elders (superiors) might actually stop someone from exposing a fraud. It is also
difficult to know whether particular virtues exist in any individuals, how to develop virtues in
individuals and groups of individuals, and how to recognize when day-to-day pressures are
eroding the virtues.

Analyzing ethical issues

Good ethical behavior needs to be guided by more than opinions, intuitions, or gut feeling.
Where the ethics of an action is in question, individuals should structure their situational analy-
sis by using a proper reasoning or decision model. Various models exist, but most involve the
following steps:

1. Clarify the facts. What is known, or what needs to be known, to help define the problem?
The facts should identify what, who, where, when, and how.
2. Define the ethical issue. What about the situation causes an ethical issue to be raised? This
logic should be phrased using the terms of one or more of the ethical models. Which stake-
holders are harmed or put at risk? Are there conflicts over rights? Is someone being treated
unfairly? Is someone acting dishonestly (lacking integrity)?
3. Specify the alternatives. List the alternative courses of action, including those that repre-
sent some form of compromise.
4. Compare values and alternatives. See if there is a clear decision. If one course of action is
so compelling, then the analysis can be concluded.
5. Assess the consequences. Identify short- and long-term, positive and negative conse-
quences for the major alternatives. This step will often reveal unanticipated results as, for
example, short-term benefits will be shown to be dwarfed by long-term costs.
6. Make a decision. Balance the consequences against the primary ethical principles or values
and select the alternative that best fits.

It is important to recognize that different people can consider identical situations and reach
different conclusions even after structuring their decision processes equally carefully and
thoroughly. This can occur because they prioritize the various ethical principles differently.
None of the ethical models is perfect and complete, and the models sometimes lead to different
conclusions. That insight is important by itself. Managers need to be open to different
approaches because different people will be viewing and judging their actions through differ-
ent lenses.

Why do people behave unethically?

People behave unethically for several reasons. One reason is ignorance. Managers who do not
understand ethics, or who do not analyze the issues carefully, can make any of a number of
mistakes that can lead to high probabilities of unethical behaviors within their organizations.
They sometimes fail to recognize some ethical issues when they arise. One common problem is
that managers sometimes equate ethical and legal issues; they conclude that if an action is not
illegal, it must be ethical. This is clearly not true. For example, it is possible to conclude that
many forms of earnings management are unethical, even though they might not be illegal.
While many laws do indeed prohibit immoral practices, it is impossible to write laws to prohibit
all unethical behaviors. Lying is usually considered immoral; however, laws prohibiting lying

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 Why do people behave unethically?

would be hard and inefficient to enforce. As a consequence, lying is against the law only in the
most important circumstances, such as perjury.
But many people behave unethically at times even when they fully understand that what
they are doing is wrong. There are some people who unscrupulously act as bad apples. They are
essentially dishonest. For them, the burden of good ethics is greater than what they are willing
to bear. Those who work in the field of fraud often refer to the so-called “10-80-10 rule,” which
maintains that approximately 10% of the population will be dishonest. These bad apples are
contrasted with the two other categories. The bulk of the population (80%) is honest most of the
time but can be tempted to be dishonest if opportunity and need arise simultaneously. The
other 10% are honest under all circumstances, even in situations where they are sure they will
not get caught.
Why someone – those in the 80% category – might act unethically can be understood in ref-
erence to the well-established fraud triangle model (Figure 15.1). Fraud is just an extreme form
of unethical behavior. The three legs of the triangle are opportunity, motivation, and rationali-
zation. Generally, all three of these factors have to be present at the same time in order for
someone to commit fraud. Opportunity is created, most commonly, in situations with poor
internal controls, little supervision, and not much checking, such as by auditors. The motives for
committing fraud can be greed or the need for money. But the motives can also be non-monetary,
such as caused by pressures to perform, which can be internally or externally generated. And
fraud is encouraged by rationalizations. People committing fraud generally know that what
they are doing is wrong, but they often find rationalizations to justify their behaviors. These
rationalizations include such justifications as “if we don’t manage earnings this quarter, we’ll
have to lay off some valued employees”; “aggressive financial reporting may not be totally
honest, but everyone does it – we’re only shooting ourselves in the foot if we don’t”; “I shouldn’t
be taking office supplies home for the kids, but some of my colleagues are doing much worse
things than I do, and it isn’t really hurting anybody”; “we’re uncomfortable about the aggressive

Figure 15.1 The fraud triangle

The Fraud Triangle

Internal Controls “The company owes me, I am underpaid.”
• None in place “Everyone else is doing it.”
• Not enforced “If they don’t know i’m doing it, they deserve to
• Not monitored lose the money.”
• Ineffective “I did it for a noble purpose.”
Too much trust “Nobody will miss the money.”
No “tone at the top” “I’ve made this company a lot of money”
y

Ra

No segregation of duties (do more “I didn’t get the bonus I deserved”

nit

with less) “I lost income due to stupid management

tio
rtu

Increased span of control = policies.”

n

less review “I’m just borrowing the money. I’ll pay it back.”
po

ali

No management oversight/ “I didn’t personally benefit.”

za
Op

knowledge
tio
n

Motivation

- Debt - Pressure to perform

- Greed - Too much work
- Vices: gambling, drugs

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Chapter 15 • Management Control-Related Ethical Issues

estimates of our tax liabilities, but we decided as a team that this was all right”; and “my boss
knows about it – she said we’ll be ok.” Some of these rationalizations stem from a poor corporate
culture. Fraudulent and unethical behaviors are contagious.
The rationalizations, and the subsequent unethical behaviors, are more common in people
who lack moral courage. These people know they are doing something wrong, but they do not
have the strength to do the right thing despite fear of the consequences. It is well known that
those who insist on acting ethically can suffer any of many negative consequences, including
shame, ostracism, and even dismissal. People with poorly formed ethical beliefs and/or little
moral courage may easily “capitulate.” Those who wish to build up their moral courage should
clarify their core values – those values they are willing to uphold regardless of the consequences.
Those who recognize that they do not have the needed moral courage should choose their
work environments carefully. They should choose environments in which it is unlikely they will
be pressured into decisions that require good ethical judgment. They may not be suitable for the
financial controller-type jobs we discussed in Chapter 14, as indeed one commentator noted
that for these jobs around the globe:

[I don’t] know of a senior financial professional who is not under pressure from others
around their organization. The difference may be that in the West they face pressure from
the executives to show bigger returns for stock markets, whereas in the East they may be
under pressure from a powerful majority shareholder to pinch profits from minority share-
holders. But they are always between a rock and a hard place. The rock and the hard place
are just different parties.25

Unethical actions that are not fraudulent differ slightly from fraudulent actions because those
acting unethically might not be aware that they are doing something wrong. They might be igno-
rant or morally disengaged. They might not recognize an ethical issue when they face one, such as
when they have an unconscious bias (which causes them to discriminate, say), so their conscience
does not stop them from behaving unethically. They do not even need a rationalization.

Some common management control-related ethical issues

Many ethical issues arise in the context of MCSs. Some people even use ethical arguments to
question the basic foundations of management “control” and “capitalist systems” that “coerce”
management into making decisions on “economic” grounds (only). They argue that “value” is
put before “values” and that corporate restructurings and downsizings aimed at reducing costs
are unethical because they put profits before employee and societal welfare. Others counter,
however, that the restructurings are necessary responses to changes in the environment. While
they may cause pain to displaced employees, they help ensure that the restructured businesses
remain competitive and, thus, able to gainfully employ their remaining employees. They call
this “creative destruction” – that is, a painful yet necessary condition for innovation and pro-
gress, affecting all sectors, not just the for-profit sector, and for which the underlying rationale
is that welfare is best served by not propping up old models but making the new ones work.26
(We discuss this further to some extent in Chapter 16.)
Such political economy-related ethics debates are, however, not within the scope of the fol-
lowing sections. Instead, in what follows, we identify and briefly discuss four narrower, but
common and important, MCS-related ethical issues: (1) creating budget slack; (2) managing
earnings; (3) responding to flawed control indicators; and (4) using controls that are “too good.”
These issues are important, and the analyses required to deal with them are representative of
those that could be used to analyze similar issues that might arise.

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The ethics of creating budget slack

As discussed in Chapter 8, many performance targets, particularly those used at managerial
organization levels, are negotiated as part of annual budgeting processes between those who
are ultimately held accountable for meeting the budget and their managers, those one step up in
the organization chain or hierarchy. Negotiation processes provide opportunities for those pro-
posing their budget to “game” the process; that is, to distort their positions in order to be given
more easily achievable targets against which they subsequently will be evaluated and on the
basis of which they typically stand to earn performance-contingent rewards.27 This distortion
is often colloquially referred to as sandbagging or creating slack. As we discussed in Chapter 5,
building slack into budgets is quite common. But is it ethical?
When employees create slack, they are exploiting their position of superior knowledge about
their entity’s prospects. They are failing to disclose to their superiors all of their available infor-
mation and informed insights and, as such, are presenting a distorted picture of their entity’s
business. Therefore, creating budget slack can be deemed in violation of several of the obliga-
tions listed in the Statement of Ethical Professional Practice of the Institute of Management
Accountants.28 For example, the credibility standard requires management accountants to
“communicate information fairly and objectively.”
Analysis from the tenets of utilitarianism also suggests that slack creation constitutes an
ethical issue. Typically, those creating budget slack will benefit personally from it. Slack pro-
tects them against unfavorable occurrences such as an increase in costs, thus mitigating the
probability that performance targets would be missed and performance-based rewards left
unearned. If the reward-performance function is continuous (i.e. not capped), slack will also
increase the size of the rewards that will be earned. Whereas these benefits accrue to those cre-
ating the slack, the slack creation can be costly to other stakeholders, especially the firm and its
owners. Budgets containing slack are often less than optimally motivating. When achievement
of the target is assured, employee effort may be waning. Moreover, exceeding the target may be
deemed unwise because it may trigger a higher, more difficult target for the following period.
This is called target ratcheting.29 Employees and managers may not work as hard, they may
make unnecessary expenditures to consume the excess, or they may be motivated to play games
to “save” the profit not needed in the current year. Slack creation also can be deemed less than
correct from the standpoint of the users of the budget submissions – higher-level management –
as they will rely on the information in the budget to make investment, resource allocation, and
performance evaluation decisions that will become distorted.
On the other hand, some arguments can be raised to support the position that slack creation
is ethical, or at least can be seen as justifiable. Many managers argue that creating slack is a
rational response within a results-control system. They do not view slack as a distortion but as a
means of protecting themselves from the downside risks of an uncertain future. Viewed this
way, slack serves a function identical to that of the accepted management accounting practices
of variance analysis and flexible budgeting, both of which are used to eliminate the effects on
the performance measures of some uncontrollable factors (see Chapter 12), and in so doing
shield managers from the risk these factors create. This protection from risk is particularly valu-
able in firms that treat the budget targets as “hard promises” or “performance commitments”
with little or no tolerance for missed targets, or “underperformance” with possible dismissal as
a consequence when it occurs. In the same way, some managers argue that budget slack is some-
times necessary to address the imbalance of power that is inherent in hierarchical organiza-
tions. It offers protection or “insurance” against evaluation unfairness that may arise from
imperfect performance measures or evaluation errors or biases by superiors.
Finally, managers who defend slack creation also often point out that it is an accepted prac-
tice in their organization’s budget negotiating process. Managers at all levels of the organization

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negotiate for slack in their budgets, and everyone is aware of the behavioral norm. Indeed, they
point out, many senior managers were promoted into their positions precisely because they
were good at negotiating for slack and, hence, for achieving their budget targets consistently
over time. In many organizations, superiors may actually (implicitly) encourage their subordi-
nates to create slack because they also benefit from it. The superiors’ targets are usually con-
solidations of the targets of their subordinates, so they enjoy the same reduction in risk and
increase in the expected values of their rewards as the slack creators. When creation of slack is
widespread and the practice is encouraged, can we say that the organizational culture is
encouraging unethical behavior? Or, does it indicate that in this community, at least, slack crea-
tion is rationalized as an acceptable behavioral norm?
Combined, then, in making judgments as to whether slack creation is ethical in any specific
setting, many factors must be considered, including the following:

● How good the performance measures are (the extent to which they reflect underlying perfor-
mance and are unaffected by factors the managers cannot control).
● Whether budget targets are treated as a rigid promise from managers to the corporation.
● Whether the manager’s intent in creating the slack primarily reflects self-interest.
● Whether (or how much) superiors are aware of the slack.
● Whether the superiors encourage the creation of slack.
● Whether the amount of slack is “material.”
● Whether the individual(s) involved are bound by one or more of the sets of standards of pro-
fessional conduct. (Most accountants are, whereas most managers are not.)

The ethics of “managing earnings”

A second ethical issue involves the data manipulation problem discussed in Chapter 5. A com-
mon form of manipulation is earnings management, which includes any action that changes
reported earnings (or any other income statement or balance sheet item) while providing no
real economic advantage to the organization and, sometimes, actually causing harm. Gener-
ally, earnings management actions are designed either to boost earnings, such as to achieve a
budget target or increase stock price, or to smooth earnings patterns to give the impression of
higher earnings predictability and, hence, lower risk. Some actions might also be designed to
reduce earnings, such as to “save” profits for a future period when they might be needed, or to
lower stock price to facilitate a management buyout, or to lower the strike price just before a
stock option grant.30
Earnings management can be deemed unethical for several reasons. First, when the actions
are not apparent to either external or internal users of financial statements or the reported
information more generically, those engaging in earnings management are deriving personal
advantage through deception. This is pertinently expressed in the following excerpt:

It would be very helpful to know where people push the boundaries. If all companies could
be ranked in terms of aggressiveness or conservative accounting policies, as judged by
their auditors, then that would be helpful information. […] If they’re pushing the envelope,
you want to know about it. If they’re pushing the envelope and technically you can’t qualify,
we don’t find out.31

Second, professional managers and accountants can be said to have a duty to disclose fairly
presented information. Indeed, most professional associations state so in their codes of ethics.
Specifically, the IMA code referenced above requires to “disclose all relevant information that
could reasonably be expected to influence an intended user’s understanding of the reports,

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 Some common management control-related ethical issues

analyses or recommendations.”32 Hence, the distortions can be interpreted as not being consist-
ent with a professional’s obligation to report and disclose information credibly.
Third, the rewards earned from managing earnings are not fair when the reported perfor-
mance is only cosmetic, not real. This is the reason for recent changes in compensation practices
that have so-called claw backs, which allow bonuses or other incentive payouts to be rescinded if
in retrospect these appeared to have been based on managed or manipulated performance.33
Managers may have several justifications for managing earnings, however. They might be
using their private information about company prospects to smooth out some meaningless,
short-term perturbations in the earnings measures to provide more, rather than less, informa-
tive performance signals to financial statement users. As with slack creation, they might argue
that they take these actions merely to protect themselves from rigid, unfair performance evalu-
ations. They might also take actions that make it unnecessary for them to take other, possibly
more damaging actions, such as suspending research and development expenditures.34 Some
earnings management actions are easy to rationalize in this way.
Curiously, most people judge accounting methods of managing earnings more harshly than
operating methods even though the purposes of the two earnings management methods are
identical, and the economic effects of the operating methods are typically far more costly to the
firm.35 As discussed in Chapter 5, accounting methods of managing earnings involve the selec-
tion of accounting methods and the flexibility in applying those methods to affect reported
earnings. Operating methods involve the altering of actual operating decisions, such as the tim-
ing of sales or discretionary expenditures. Clearer standards for judging accounting perfor-
mance (i.e. accounting standards) could explain this finding. As such, employees may be less
likely to engage in earnings management (or other questionable behaviors) when they believe it
violates established rules, which accounting standards are, suggesting that people use clarity of
laws, rules, standards, or procedures as a basis for reaching an ethical conclusion.
Several situational factors are likely to influence judgments as to whether earnings manage-
ment actions are deemed (un)ethical, including (1) the direction of the manipulation (boost,
shrink, or merely smooth earnings); (2) the size of the effect (materiality); (3) the timing (quar-
ter- vs. year-end, random timing vs. immediately preceding a bond offering or stock option
grant); (4) the method used (adjusting reserves, deferring discretionary expenditures, or
changing accounting policies); (5) the managers’ intent regarding the informativeness of the
numbers (and disclosures); (6) the clarity of the rules prohibiting the action; and (7) the degree
of repetition (one-time use vs. ongoing use even after a warning).
Making judgments about earnings management is complex, although in so doing, it is proba-
bly judicious to err on the side of caution rather than rationalization. Speaking out against what
he deemed unrelenting earnings management practices, Arthur Levitt, former chairman of the
Securities and Exchange Commission (SEC), called these practices so serious that “we need to
embrace nothing less than a cultural change.”36 The incidence and size of various corporate
scandals and failures, including in major financial institutions such as Bear Stearns and Lehman
Brothers in only the first decade of the twenty-first century, seem to have proven him right.37

The ethics of responding to flawed control indicators

Results targets and action prescriptions provide signals to employees as to what the organization
considers important, be it profits, growth, quality, or any other desired performances. When the
targets and prescriptions are not defined properly, they can actually motivate behaviors that
employees know are not in the organization’s best interest. The employees earn rewards for doing
what they are asked to do, not what they know they should do, and the organization suffers. Indeed,
many fraud cases involve employees taking unethical and illegal actions that they perceive to be
“necessary” for their company to thrive or survive, sometimes under pressure from higher-ups,38

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Chapter 15 • Management Control-Related Ethical Issues

but about which they are too ashamed or embarrassed to tell their relatives. This is pertinently
expressed in the following quote from a letter by Matthew Lee, a Lehman Brothers senior vice
president who believed “senior management” may have violated their own internal code of ethics
by misleading investors and regulators about the true value of the then-firm’s assets:

“I believe the manner in which the firm is reporting [certain] assets is potentially misleading
to the public and various governmental agencies,” Mr. Lee wrote.39

Mr. Lee addressed his letter to the then-CFO, among others, only days before he was ousted
from the firm.
We discussed one common flawed-response example in detail in Chapter 11 – that of myopia.
It occurs when companies place a high emphasis on the achievement of short-term profit tar-
gets, even though some profit-increasing activities (such as reducing investments in employee
development, customer acquisition and loyalty, or R&D) may diminish shareholder value in the
long run. Relevant to the discussion here, managers who engage in myopic behaviors often
know that they are curtailing long-term value or even causing long-term harm to their entity
and their company; yet, perhaps under pressure, they decide to do it anyway.
What should employees do if they know the results measures or action prescriptions are flawed?
Should they act to generate the results for which they will be rewarded, or should they sacrifice their
own self-interest in favor of what they believe to be “truly” best for the organization? When they face
this conflict of interest, most employees will choose to follow the rules of the reward system, perhaps
while lobbying to get the measures changed. This behavioral norm might not be ethical. Financial
professionals have standards of ethical conduct (duties) that require them to further their organiza-
tion’s “legitimate interests.” For example, Financial Executives International’s Code of Ethics requires
its members to “Act in good faith, responsibly, with due care, competence and diligence, without
misrepresenting material facts or allowing one’s independent judgment to be subordinated.”40
Managers and employees not bound by those professional standards perhaps should be
bound by a sense of loyalty (a virtue) to their organization. But not everyone is. This is the rea-
son why, applied to the banking sector, some financial markets have taken drastic steps to try to
boost ethics in their country’s financial services. In the Netherlands, for example, top bankers
must already swear an oath to behave with integrity, and the industry body will extend the oath
to cover bankers at lower levels.41

The ethics of using control indicators that are “too good”

Another ethical issue relates to the use of control indicators that are too good. Highly, perhaps
excessively, tight control indicators have been made possible by advances in technology. For exam-
ple, computer surveillance programs that allow companies to monitor their employees’ personal
computer screens, data use, and Internet traffic are widespread today. Supervisors can listen in on
employees’ sales calls; cameras can record all the actions some employees take; computers can
count the number of keystrokes by data entry clerks and telephone operators to gauge productivity;
and location devices can track an employee’s whereabouts throughout the workday.42 A recent
example from Credit Suisse, the Swiss-based global bank, illustrates this trend very well:

In truth, errors and misbehavior happen everywhere. In a well-run institution, though, man-
agers spot problems early. Then measures are taken to limit the damage and make amends.
Culture is key, but so are resources. […] In that context, Credit Suisse’s announcement
makes perfect sense. It has joined forces with Palantir, a CIA-backed artificial intelligence
firm, to use data-driven behavioral analysis to root out rogue traders and insider dealing.
Mr. Thiam [the bank’s chief executive] says he wants to change Credit Suisse’s culture. But
if his employees don’t feel comfortable admitting to problems, at least his bank will soon
be a lot better at catching them.43

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 Spreading good ethics within an organization

What is the ethical issue? The number of correct keystrokes and reports of employees’ loca-
tions-by-time may be good results measures in certain situations. They may describe what the
organizations want from their employees, and they can be measured accurately and on a timely
basis. That said, there is a fine line between the employer’s right to monitor and the employees’
rights to autonomy, privacy, or freedom from oppressive controls that suggest they are working
in electronic sweatshops. Thus, questions relevant to determinations of whether use of such
measures is ethical probably include:

● Is the use of the measures disclosed to employees?

● Are safeguards in place to protect the collected data?
● Are safeguards in place to ensure that the data are used for their intended purposes only (e.g.
for quality monitoring of customer calls, or for monitoring employees in training, not experi-
enced employees)?
● When supervisors use these tight controls, do they emphasize quality rather than just quan-
tity (“grab everything”)?

But some companies also make the news with allegations of subjecting their employees to
conditions that presumably resemble an era of physical sweatshops. For example, when 11
employees committed suicide in a short period, the Taipei-based company Foxconn “was intro-
duced to much of the world in the worst terms imaginable – as an industrial monster that treats
workers like machines […] to make products like the iPhone at seemingly impossible prices.”
For the image-conscious businesses that Foxconn supplies, including IBM, Cisco, Microsoft,
Nokia, Sony, HP, and Apple, the suicides were a public-relations nightmare and a challenge to
the “off-shoring strategies” that were essential to their bottom lines.44 But whether Foxconn’s
controls were “too tight” is actually difficult to judge. “[Foxconn] pays workers on time and for
overtime according to the regulations, and that’s why workers always queue to work there,”
said Geoffrey Crothall, spokesman for Hong Kong-based China Labor Bulletin, a worker-rights
organization, adding that “despite […] the intense nature of the work, it’s still better than a
small workshop with no guarantee you’ll get paid.”45 An anonymous former employee said:
“The factories themselves are top notch although they are fairly intense working environments.
Westerners would find it very difficult to work there.”46
Clearly what is acceptable to some is not acceptable to others, and, as the last quote sug-
gests, views may differ across (national) cultures. What is clear, however, is that when con-
trols are “too good” or “too tight” – or “oppressive,” as some would argue – they are likely to
induce unintended and/or undesirable consequences, such as by triggering job-related ten-
sion and even stress-related health complaints. This may be especially true for action controls;
indeed, at Foxconn, it was said that “obviously work is tiring and there’s pressure; there are
lots of rules here.”47 But results controls can also be “too tight” in that they induce myopia and
pressures for earnings management, as we discussed earlier in this chapter and elsewhere in
this text.

Spreading good ethics within an organization

Ethical progress within an organization typically proceeds in stages. In an early stage, when the
organization is small, the organization becomes an extension of the founder or the top manage-
ment group. The founder acts as a role model, setting the ethical tone, and is usually able to
monitor employees’ compliance with that tone.
In later stages of development, organizations implement more formal corporate ethics pro-
grams. These programs include three main elements. First is a set of policies, codes, and values

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Chapter 15 • Management Control-Related Ethical Issues

that define how the organization wants its employees to act. These policies might originate first
in a set of memoranda from top management, but in larger organizations, they evolve into
formal policy manuals and codes of ethics or codes of conduct. Some of the behavioral prescrip-
tions might be quite specific, such as “accept no gifts greater than $50 in value.” But necessarily,
because not every possibility can be foreseen, some guidance is quite general. It is common to
list a set of organizational values that employees are expected to live up to, such as the virtues
mentioned earlier in this chapter.
Second is a set of programs designed to ensure that employees understand the specific
policies and to help them think through ethical issues that are not specifically spelled out in
the written prescriptions. Oftentimes, companies ask their employees to sign a statement
certifying that they understand and will abide by the rules. At Boeing, the large aircraft
manufacturer, employees are asked to certify annually that they will adhere to the compa-
ny’s Code of Conduct, which outlines the ethical business conduct required of employees in
the performance of their company responsibilities. The company website explains that
“Individuals certify that they will not engage in conduct or activity that may raise questions
as to the company’s honesty, impartiality or reputation or otherwise cause embarrassment
to the company.”48
Reinvigorating a code of conduct is also sometimes an effective way to reinforce change, to
send a clear signal. This happened when Antony Jenkins, boss of Barclays, the UK-based global
bank, told the bank’s 140,000 employees to sign up to a new code of conduct, or leave.
Following from this, good ethics programs must involve some enforcement mechanisms,
which include monitoring and application of sanctions where called for. The monitoring might
be informal, such as is done by direct supervisors, or it might involve formal investigations by
internal or external auditors, or even law enforcement agencies.
The codes also might need updating from time to time, even though the underlying princi-
ples of good ethical conduct may remain largely the same. For example, at Google, the docu-
ment that lays out the company’s “Ten Things” of their corporate philosophy states right at the
top: “We first wrote these ‘10 things’ several years ago. From time to time we revisit this list to
see if it still holds true. We hope it does – and you can hold us to that.”49
Even the best laid-out codes of ethics and signed employee certification statements may not
be sufficient. Consider the following excerpt from the Statement of Vision and Values Principles
of a large publicly traded corporation:

Because we take our responsibilities to our fellow citizens seriously, we act decisively to
ensure that all those with whom we do business understand our policies and standards.
Providing clearly written guidelines reinforces our principles and business ethics. [Our]
employees at all levels are expected to be active proponents of our principles and are
trained to report without retribution anything they observe or discover that indicates our
standards are not being met.
Compliance with the law and ethical standards are conditions of employment, and vio-
lations will result in disciplinary action, which may include termination. New employees are
asked to sign a statement indicating that they have read, understand and will comply with
this statement, and employees are periodically asked to reaffirm their commitment to these
principles.

Which company, do you reckon, espoused these principles and required signed statements
certifying understanding and compliance with the principles? It was Enron, a corporation now
held up as the epitome of corporate evil!50
This Enron example shows that merely having a set of ethical standards and rules and taking
steps to ensure that employees have read them is not sufficient. The standards must be made

690
 Conclusion

operational. Top management must set a credible tone at the top, and they must endeavor to
maintain a good internal MCS so that potential violators know that there is a good chance that
they will be caught. Monitoring should be done by both employees’ superiors, colleagues
(mutual control), and internal auditors. Violators of the rules should be sanctioned. These sanc-
tions help give employees the courage to resist counter pressures. Companies also often appoint
a designated ombudsperson to help employees facing ethical issues.
Tone at the top can be an effective form of cultural control when it is consistent, and supervi-
sion and mutual monitoring can be effective when given teeth in an otherwise trusting organi-
zational climate. Under effective corporate cultures, ethical behaviors are “shaped” rather than
merely “enforced” from time to time, often after a major violation has occurred and damage has
been done.

Conclusion

This chapter has provided a brief introduction to the topic of ethics as it relates to the design and
use of MCSs. To create the right ethical environment, management must have moral expertise
and know where and how to provide it.
The sampling of issues discussed in this chapter should have made it obvious that many ethi-
cal issues are MCS-related, and many important ethical issues do not have black or white
answers. One cannot conclude unequivocally that, for example, creating budget slack is always
unethical or that controls are too tight to be ethical. The “greyness” of the judgments makes it
all the more important for managers to subject the various ethical issues to a formal analysis.
That said, many situational factors must be considered in making ethical judgments. For exam-
ple, judgments of what is ethically acceptable vary across national cultures, suggesting that
multinational companies wishing to achieve similar levels of ethicalness across entities located
in different countries will have to rely on different sets of controls.
Employees face many pressures and temptations that can cause them to act unethically.
They can easily bow to performance deadlines and crises, reward temptations, pressures for
conformity, and even counterproductive orders from their bosses. Unless managers act to
deflect these pressures and temptations on a fairly consistent basis, their company’s ethical
climate will be weakened. Managers must help guide the behaviors of their employees who
are incapable of thinking through ethical issues (distinguishing right from wrong) them-
selves. They must understand how and why individuals will reach different ethical conclu-
sions, and, importantly, they must take a stance as to how they want employees in their
organization to behave.
Every organization has an ethical culture or climate of some sort; either good, bad, or
mixed. It is important for managers to build a good ethical climate, one that respects the rights,
duties, and interests of stakeholders inside and outside the firm. An organization that fosters
unethical behaviors from its employees, even those that benefit the company in the short run,
will probably eventually find itself the victim of its own policies. Such organizations are more
likely to attract people who feel comfortable bending the rules; they may even entice sincere
people to bend the rules. Bad cultures are contagious. Yet, weakened or poor ethical climates
can lead to unethical behaviors that can damage or destroy individual and organizational rep-
utations. Once ethical climates are weakened and reputations are damaged, they can be quite
difficult to rebuild.

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Chapter 15 • Management Control-Related Ethical Issues
Notes
1 See, for example, H. Mintzberg, Developing Managers, Not
MBAs (Harlow, UK: Financial Times/Prentice Hall,
2005).
2 See, for example, “Shareholders vs. Stakeholders: A New
Idolatry,” The Economist (April 24, 2010), online at econ.
st/KA1p7h; “Maximizing Shareholder Value: The Goal
That Changed Corporate America,” The Washington Post
(August 26, 2013), online at wpo.st/8EXX1.
3 See, for example, “Scathing Report Says Toshiba CEOs
Had Role in Accounting Scandal,” The Financial Times
(July 20, 2015), online at on.ft.com/1KgFnZB.
4 “Ebix’s Raina Loses Magic Touch as U.S. Probes Account-
ing,” Bloomberg (June 20, 2013), online at www.bloomb-
erg.com.
5 American Institute of Certified Public Accountants, AICPA
Code of Professional Conduct (see, for example, on page 5
of the version most recently available as of this text edi-
tion on October 26, 2015), online at www.aicpa.org/
Research/Standards/CodeofConduct.
6 “Christine Lagarde Calls for Shake-Up of Bankers’ Pay,”
The Financial Times (May 6, 2015), online at on.ft.
com/1hgJZCY.
7 “A Bigger Stick,” The Economist (June 13, 2015), online at
econ.st/1MsDNRB.
8 See “Why Honesty Is the Best Policy,” The Economist
(March 9, 2002), online at econ.st/JxdsXd.
9 See, for example, “Findings on Lehman Take Even Experts
by Surprise,” The New York Times (March 12, 2010),
online at nyti.ms/1UFar9L.
10 See, for example, “Accounting Scandal Set to Shake Up
Toshiba,” The Financial Times (July 16, 2015), online at
on.ft.com/1fMNz7h.
11 See also “Bankers Not Only Ones Pushing Ethical Bound-
aries,” The Financial Times (September 25, 2015), online
at on.ft.com/1FmAXiS.
12 “Tesco Was Warned in 2010 about ‘Aggressive Account-
ing,’” BBC (September 25, 2014), online at www.bbc.
co.uk/news/business-29364273.
13 “Tesco in Crisis: UK Managing Director among Four Exec-
utives Suspended after Exposure of Accounting Scandal,”
The Independent (September 22, 2014), online at www.
independent.co.uk. See also “Not So Funny: Booking Rev-
enues, Like Comedy, Is All about Timing,” The Economist
(September 27, 2014), online at econ.st/1qxwvPw.
14 See, for example, “A Bigger Stick,” op. cit.
15 For an overview and more detailed treatment of some of
these ethical models, see J. Gaa and R. Ruland (eds.), Eth-
ical Issues in Accounting (Sarasota, FL: American Account-
ing Association, 1997). See also J. Driver, Ethics: The
Fundamentals (Oxford: Wiley-Blackwell, 2006).
16 See also, J. Driver, Consequentialism (New York: Rout-
ledge, 2011).
17 See, for example, D. Birch and J. Fielder, The Ford Pinto
Case: A Study in Applied Ethics, Business, and Society
(Albany, NY: State University of New York Press, 1994).
692
18 See, for example, “Executive Pay ‘180 Times Average,’
Report Finds,” BBC (July 14, 2014), online at www.bbc.
co.uk/news/28286264; “City Leaders Urge Radical
Reforms of ‘Unfair’ Executive Pay,” The Financial Times
(May 8, 2016), online at on.ft.com/1T5Qnel.
19 See also J. Gaa and R. Ruland, “Ethics in Accounting: An
Overview of Issues, Concepts and Principles,” in Gaa and
Ruland, Ethical Issues in Accounting, op. cit.
20 The Statement of Ethical Professional Practice from the
IMA is available at www.imanet.org/tools-and-resources/
ethics-center (accessed May 6, 2015).
21 The Financial Executives International (FEI) Code of Eth-
ics can be found at www.financialexecutives.org/about/
FEICodeofEthics.pdf (accessed May 6, 2015).
22 “Alphabet Drops Google’s Famous ‘Don’t Be Evil’ Motto,”
Fortune (October 25, 2015), online at for.tn/1j93MVV.
23 See Google Code of Conduct at abc.xyz/investor/other/
google-code-of-conduct.html. The Alphabet version can
be found at abc.xyz/investor/other/code-of-conduct.
html (as accessed on May 6, 2015).
24 See Google Code of Conduct, op. cit.
25 Chartered Institute of Management Accountants, Global
Perspectives on Governance: Lessons from East and West
(2010), p. 8, online at www.cimaglobal.com.
26 See, for example, “Creative Destruction,” The Economist
(June 28, 2014), online at econ.st/1v8uCMm.
27 See also M. Jensen, “Corporate Budgeting Is Broken: Let’s
Fix it,” Harvard Business Review (November 2001),
pp. 94–101; M. Jensen, “Why Pay People to Lie?” The Wall
Street Journal (January 8, 2001), p. A32; and “Companies
Get Budgets All Wrong,” The Wall Street Journal (July 22,
2013), online at on.wsj.com/1OfjJaR.
28 Statement of Ethical Professional Practice, IMA, op. cit.
29 For an academic treatment of budget ratcheting, see R. J.
Indjejikian, M. Matějka, K. A. Merchant, and Wim A. Van
der Stede, “Earnings Targets and Annual Bonus Incen-
tives,” The Accounting Review, 89, no. 4 (July 2014),
pp. 1227–58, as well as the other papers in this issue of
The Accounting Review titled “A Forum on Ratcheting and
Incentives.”
30 For a more extensive discussion of earnings management
practices, see C. Mulford and E. Comiskey, The Financial
Numbers Game: Detecting Creative Accounting Practices
(Chichester, UK: John Wiley & Sons, 2002). See also J.
Graham, C. Harvey, and S. Rajgopal, “The Economic
Implications of Corporate Financial Reporting,” Journal
of Accounting and Economics, 40, no. 1–3 (December
2005), pp. 3–73; I. D. Dichev, J. R. Graham, C. R. Harvey,
and S. Rajgopal, “Earnings Quality: Evidence from the
Field,” Journal of Accounting and Economics, 56, nos. 2–3
(Supplement, December 2013), pp. 1–33; and A. Edmans,
L. Goncalves-Pinto, Y. Wang and M Groen-Xu, “Strategic
News Releases in Equity Vesting Months,” Working Paper
(2016), online at papers.ssr n.com /sol3/papers.
cfm?abstract_id=2489152.

31 “Assurance Today and Tomorrow,” PwC (2012), online at
w w w.pwc.com/gx/en/audit-ser vices/publications/
assets/pwc-global-investor-survey.pdf.
32 Statement of Ethical Professional Practice, IMA, op. cit.
33 See, for example, “Five Trends in Stock Compensation,” HR
Times (March 20, 2014), online at hrtimesblog.com; “UK
Bankers Face Tough Bonus Clawbacks,” The Financial Times
(July 29, 2014), online at on.ft.com/1k5Te8U; “SEC
­Proposes Rules on Executive Pay and Performance,” The New
York Times (April 29, 2015), online at nyti.ms/1OeoKcQ.
34 See, for example, J. Graham, C. Harvey, and S. Rajgopal,
“Value Destruction and Financial Reporting Decisions,”
Financial Analysts Journal, 62, no. 6 (November 2006),
pp. 27–39.
35 K. Merchant and J. Rockness, “The Ethics of Managing
Earnings: An Empirical Investigation,” Journal of
Accounting and Public Policy, 13, no. 1 (Spring 1994),
pp. 79–94. For another study of how ethical judgments of
earnings management vary across different user groups
(shareholders vs. non-shareholders), see S. Kaplan, “Fur-
ther Evidence on the Ethics of Managing Earnings: An
Examination of the Ethically Related Judgments of Share-
holders and Non-Shareholders,” Journal of Accounting
and Public Policy, 20, no. 1 (Spring 2001), pp. 27–44.
36 A. Levitt, The Numbers Game, Speech at New York Univer-
sity Center for Law and Business (September 28, 1998).
37 See, for example, “Findings on Lehman Take Even Experts
by Surprise,” The New York Times (March 12, 2010),
online at nyti.ms/1UFar9L. See also “Bankers Not Only
Ones Pushing Ethical Boundaries,” The Financial Times
(September 25, 2015), online at on.ft.com/1FmAXiS.
38 See, for example, “WorldCom Official Tried to Quash
Employee’s Accounting Concerns,” The Wall Street Jour-
nal (August 27, 2002), p. B6.
39 “Lehman Insider’s Letter Warned about Violating Code of
Ethics,” The Wall Street Journal (March 20, 2010), online
at on.wsj.com/1zkM59z.
Notes
40 Financial Executives International Code of Ethics, FEI, op. cit.
41 “Banking Conduct Body Faces Rocky Road to Reform,”
The Financial Times (May 19, 2014), online at on.ft.
com/1jOhPbk.
42 See, for example, H. J. Wilson, “Wearables in the Work-
place,” Harvard Business Review (September 2013), online
at hbr.org/2013/09/wearables-in-the-workplace; “Track-
ing Workers’ Every Move Can Boost Productivity – and
Stress,” The Los Angeles Times (April 8, 2013), online
a t w w w. l a t i m e s . c o m / l a - f i - h a r s h - w o r k- t e c h -
20130408,0,6413037.story; “A High-Tech New Way for
Your Boss to Follow You Everywhere,” Bloomberg (August
1, 2014), online at bloom.bg/1TTKSOI; “Wearables at
Work: The New Frontier of Employee Surveillance,” The
Financial Times (June 8, 2015), online at on.ft.
com/1IB7dz1; “Banks Listen in to Traders’ Banter for Evi-
dence of Market Abuse,” The Financial Times (February
14, 2016), online at on.ft.com/1odkTb1.
43 “Credit Suisse Spooked by What Lurks Within,” The
Financial Times (March 25, 2016), online at on.ft.
com/1RAT5Vt.
44 “Everything Is Made by Foxconn in Future Evoked by
Gou’s Empire,” Business Week (September 9, 2010), online
at www.bloomberg.com.
45 Ibid.
46 “Foxconn Suicides: ‘Workers Feel Quite Lonely,’” BBC
(May 28, 2010), online at www.bbc.co.uk.
47 Ibid.
48 See Boeing’s website at www.boeing.com/principles/eth-
ics-and-compliance.page, and specifically www.boeing.
com/resources/boeingdotcom/principles/ethics_and_
compliance/pdf/english.pdf for the document that
employees sign.
49 See www.google.com/intl/en/about/company/philoso-
phy (accessed May 6, 2015).
50 Enron’s Code of Ethics (July 2000), online (no longer
available).
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Chapter 15 • Management Control-Related Ethical Issues
CASE STUDY
Two Budget Targets
In the three years since he had been appointed man-
ager of the Mobile Communications Division (MCD) of
Advanced Technologies Corporation (ATC), Joe super-
vised the preparation of two sets of annual budget
numbers. When ATC’s bottom-up budgeting process
began, Joe instructed his subordinates to set aggressive
performance targets because he believed such targets
would push everyone to perform at their best.
Then, before Joe presented his budget to his superiors,
he added some management judgment. He made the fore-
casts of the future more pessimistic, and he added some
allowances for performance contingencies to create what
he called the easy plan. Sometimes the corporate manag-
ers questioned some of Joe’s forecasts and asked him to
raise his sales and profit targets somewhat. However,
MCD operated in a rapidly growing, uncertain market
that Joe understood better than his superiors, and Joe
This case was prepared by Professor Kenneth A. Merchant.
Copyright © by Kenneth A. Merchant.
CASE STUDY
Conservative Accounting in the General Products Division
The year 2015 was a good one for the General Prod-
ucts Division (GPD) of Altman Industries, Inc., a large
industrial products manufacturer. Sales and profits
in the division were significantly above plan due
largely to unexpectedly brisk sales of a new product
introduced at the end of 2014. The good fortune
induced Robert Standish, the GPD general manager,
694
was a skillful and forceful negotiator. In each of the past
three years, the end result was that the targets in the offi-
cial budget for MCD were highly achievable. MCD’s per-
formance had exceeded the targets in the easy plan by an
average of 40%, and Joe earned large bonuses. Joe did
not show his superiors the targets his subordinates were
working toward, but some of Joe’s direct reports were
aware of the existence of the easy plan.
In his subjective evaluations of his subordinates’
performances for the purposes of assigning bonuses
and merit raises, Joe compared actual performance
with the aggressive targets. In the last three years, only
approximately 25% of the aggressive targets had been
achieved. Joe did not fire any of his managers for fail-
ing to achieve their targets, but he reserved the vast
majority of the discretionary rewards for the managers
who had achieved their targets.
to think about how he could save some of the profits
for periods in which he might need them more. He
believed that GPD’s plan for 2017 would be tough to
achieve because the corporation as a whole was not
doing well, and corporate managers would expect
GPD to show growth even above this year’s abnor-
mally high sales and profit levels. In addition, already

in September 2016, Robert was sure that his divi-
sion’s 2016 profit would exceed the level above which
no additional bonuses were awarded for higher per-
formance – 120% of plan. Robert wanted to save
some of the 2016 profits so that he could report them
in a year in which they would augment his bonus and
those of his direct reports.
Robert asked his staff to do what they could before
the end of the year to “stash some acorns” that he could
use in future years. He suggested to Joanne, his con-
troller, that she start preparing the pessimistic scenar-
ios that could be used to justify the creation of
additional reserves and start thinking about how
This case was prepared by Professor Kenneth A. Merchant.
Copyright © by Kenneth A. Merchant.
CASE STUDY
Education Food Services at Central Maine State University
Pam Worth, Manager of Education Food Services at
Central Maine State University (CMSU), is meeting
with a researcher to explain some apparent discrepan-
cies in last year’s budgeted figures and the actuals. The
researcher, a faculty member at another university, is
doing field studies in the food service business. Pam is
explaining why she always tries to hide some slack in
her numbers when she prepares her budget. She says
that it is her understanding that she is just doing what
others in her company and in her industry do. She
agreed to speak to the researcher only with guarantees
of strict confidentiality.
I like to have a moderate cushion in my budget. The
stakes are high. If I make my budget my perfor-
mance review will be good, almost regardless of
whatever else I do during the period, and I will earn
my 20% bonus. If I miss my budget without valid
reasons I may not be allowed to keep my job.
More than that, however, the cushion in the
budget allows me to do a better job. I don’t have
Education Food Services at Central Maine State University
expenses could be accelerated and revenues could be
deferred at year-end.
Joanne was uncomfortable. She reminded Robert
that because of continuing order declines, Altman
executives were looking for ways to report higher, not
lower, profits in the current year and that if that situa-
tion did not turn around quickly, layoff s were threat-
ened.
But Robert explained that GPD would still be report-
ing very high profits; he just wanted to save a portion of
the excess above plan. And in any case, GPD could not
help the corporation much because it was such a small
part of the entire corporation.
to worry that my staff is working at peak effi ciency
all the time, so I don’t have to supervise every
action. That is better for the staff, also; they hate
it when I’m looking over their shoulders. The
cushion also allows me to buy things that I can
use to provide the university with better service.
For example, this year I was able to buy several
portable bars that we have used already for some
parties.
Pam, an accounting graduate of Northern Univer-
sity, is an employee of Contract Food Services Corpora-
tion (CFSC), a large corporation that provides food on a
contract basis to universities, hospitals, and businesses.
Pam runs a profit center that provides services only to
one university – CMSU. Her operation provides food at
two major, on-campus cafeterias serving 12,000 stu-
dents and nearly 2,000 faculty and staff. Pam also has
responsibility for the vending machine business on
campus, and her employees sometimes provide cater-
ing services for on-campus business meetings. Pam’s
695
Chapter 15 • Management Control-Related Ethical Issues
operation employs 59 regular employees and between
150 and 180 students on a part-time basis. Annual rev-
enues are slightly in excess of $3 million.
Relations between CFSC and CMSU are governed by
a contract that is renegotiated each January for the fol-
lowing academic year. The contract defines the respon-
sibilities of each part y. For example, CMSU
administrators are given the power to review and
approve CFSC’s service plans and prices. The university
provides all equipment costing over $100. CFSC sets
the menus and hires the employees.
The contract also defines limits on the profits CFSC
can earn from the CMSU operation. CFSC earns 100%
of the profits from the food operation up to a limit of
10% profit on sales. Beyond that limit, profits are split
equally with CMSU. The contract is set this way as an
incentive to CFSC managers to provide extra quality
and services after they have ensured themselves a rea-
sonable profit.
Budgets are prepared on a bottom-up basis. In July,
corporate headquarters personnel send planning guide-
lines and assumptions (e.g. employee benefits, infla-
tion) to all operating units. The operating managers
forecast their customer counts, which determines their
food requirements, and then estimate their operating
costs for the 18-month period starting in January. Since
the university owns the buildings and equipment, the
bulk of CFSC’s costs are for food and labor.
After the units’ budgets are prepared, a series of
budget challenge rounds are held to review the numbers
at successively higher CFSC consolidation levels –
district, region, division, group, and corporate. If the
numbers meet the managers’ profit expectations,
the budgets are accepted. Typically, however, each of the
managers in the hierarchy is asked to raise his or her
profit targets. These requests lead to a series of meetings
designed to explore whether revenue projections should
be raised or cost projections cut. The size of these profit
This case was prepared by Professor Kenneth A. Merchant.
Copyright © by Kenneth A. Merchant.
696
increase requests are not predictable, but in recent years
they have ranged from zero to 15%.
Pam explains that she routinely hides some cushion
in both labor and food costs:
I can build the budget cushion in a lot of places. This
year for example:
● I kept the proportion of meals served on board con-
tracts (which are more lucrative for us) equivalent to
last year’s level even though I know that proportion
will be growing because the trend is to have more
students living on campus.
● I planned for a number of labor hours at $7.15 when
I knew that I would hire students for those hours,
and students don’t earn that much.
● I planned no efficiency improvements when I know
we almost always improve our efficiency. There is a
learning curve in this business. My superiors know
about this learning curve too – they ran operations
just like this – but they don’t object to my having a
cushion. It is to their advantage to have me meet my
budget too.
These types of things add up. I put just enough in so
that I am sure I will be able to meet my budget targets
even after corporate management squeezes some of my
cushion out in their reviews.
I know more about what is happening at CMSU than
anyone else. My bosses can’t come here and check
every assumption that I have in the plan. They don’t
have the time. My immediate boss, for example, is
responsible for nine units spread over a fairly large geo-
graphic area.
You can easily identify new managers – they submit
budgets that are realistic. Experienced managers build
in pads for themselves. It’s a bit devious, sure, but it’s
not theft. It’s just playing with projections. The money’s
there. Besides, if you don’t build a cushion for yourself
you’re not going to survive for long in this business.

CASE STUDY
The “Sales Acceleration Program”
In early October, Priscilla Musso, general manager of
the Specialty Products Division (SPD) of Consolidated
Furniture Corporation (CFC), was studying the divi-
sion’s third quarter fi nancial reports. Sales were run-
ning significantly below plan, and it became quite clear
to Priscilla that SPD would need strong performance in
the last quarter of the year in order to reach its annual
profit target. Meeting budget was very important to
Priscilla and her management team because they were
included in CFC’s lucrative executive bonus program,
and they would lose all of their bonus opportunities if
SPD did not achieve the profit targets.
To brainstorm for ideas, Priscilla called her manage-
ment team together. At first the managers on the team
expressed only discouragement. Everybody had been
working hard, but the market was softening, and com-
petitors were being very aggressive.
Then, after some delay with nobody else suggesting
any options, Jonathan Robbins, SPD’s manager of sales
and marketing, suggested that the division could imple-
ment a new sales program to pull some sales that might
ordinarily be made next year into the current year. Any
customers who accepted delivery in the fourth quarter
would not have to pay their invoice for six months.
(Normally payments in the industry were to be made
within 30 days.)
Priscilla’s first reaction was favorable; this program
might, indeed, achieve the desired result. But she asked
the members of her team for their reactions.
Shirley Covey, manager of human resources noted
that if this program was successful, it would probably
cause SPD’s employees to have to work overtime at the
end of the year, and that was something they tradition-
ally did not want during the holiday season. But Priscilla
reminded Shirley that the employees would be paid time-
and-a-half for all the overtime hours that they worked.
This case was prepared by Professor Kenneth A. Merchant.
Copyright © by Kenneth A. Merchant.
The “Sales Acceleration Program”
Priscilla asked Bill Bennett, SPD’s controller, if this
program would violate any accounting rules. Bill said
there would be no problem recording the sales as long
as the items were shipped and billed before December
31. The accounting would be consistent with GAAP. But
Bill cautioned that this program was probably only pro-
viding a short-term, cosmetic profit improvement.
While it might well make the current year look better, it
would probably cause significantly lower sales to be
recorded in the first quarter of next year. So next year
the division would start in a deep hole. They would be
scrambling all year to trying to dig themselves out of
that hole, with no guarantees that they could pull it off.
It was just postponing the problem. In addition, Bill
reminded the team that this program would be very
expensive. On top of the overtime expense that would
have to be incurred in the production areas, the pro-
gram would greatly increase SPD’s accounts receivable.
CFC was currently paying about 12% on its lines of
credit, so this increase in working capital would be
quite expensive for the corporation.
But Priscilla cut Bill short. She reminded him that
CFC did not allocate interest expenses to SPD, so she
was not particularly concerned about the corporation’s
increased borrowing costs. She was more worried with
her superiors’ negative reactions if she did not make
this year’s profit plan than she was about their reac-
tions to her allowing the receivables’ balance to
increase in the early part of the year. And while she
acknowledged that they might be creating a problem
for next year, she suggested it would be best to worry
about that problem when, and if, it became real.
With no other options on the table to solve the cur-
rent year’s budget problem, the SPD managers decided,
unanimously, to implement what they called the “Sales
Acceleration Program.”
697
Chapter 15 • Management Control-Related Ethical Issues
CASE STUDY
The Expiring Software License
On September 30, Jianxin (Jimmy) Wu, manager of the
Information Systems Department for Southwest Indus-
tries (SWI), was in panic mode. SWI was a medium-
size manufacturer of portable shelters, tents, and
awnings. Jimmy was panicking because the company’s
Citrix software had just died. Because of his oversight,
an invoice had not been paid, and the SWI’s license to
use the software had expired.
Jimmy knew that something had to be done very
quickly. Many of the company’s information systems
users, who were situated at three different locations,
relied heavily on the Citrix software. All of SWI’s applica-
tions ran under Citrix. The Citrix software gave all
employees access to the SWI applications they needed no
matter where they were, as long as they had access to the
Internet. The Citrix license renewal would cost $3,600,
but going through the purchasing department to get a
requisition issued would take several days. The users
could not be without the Citrix capability for that long.
Then Jimmy thought about using his purchasing
card. The card, which worked like a credit card, was
This case was prepared by Professors Kenneth A. Merchant and Leslie R. Porter.
Copyright © by Kenneth A. Merchant and Leslie R. Porter.
698
intended for small purchases, not including travel,
hotels, or food. SWI issued the card to some of its key
personnel to avoid the costs of processing the paper-
work required for many small, incidental purchases.
The company only had to make one single payment to
the credit card company, and the credit card company
did all the processing.
The maximums placed on Jimmy’s card were $2,000
for any single purchase, and $5,000 per month. Jimmy
knew that these limits were strictly enforced. Person-
nel in the accounting department scanned the bills
monthly looking for violations. But Jimmy thought that
he could get Citrix to split the bill in two, and then the
accounting department personnel would not raise any
objections.
With no other apparent options at hand, Jimmy
decided to try to use his card to renew the license. The
Citrix salesman agreed to charge the card in two trans-
actions of $1,800 each. The license was renewed
quickly, and few of SWI’s Citrix users were ever aware
that there had been a problem.

CASE STUDY
Wired, PLC
Don Sperber was the CFO of Wired, PLC, the Thailand
subsidiary of Wunderphone, a large telecommunica-
tions company based in Germany. Wunderphone
owned 70% of Wired. The other 30% was listed on the
Bangkok stock exchange and publicly traded. Wunder-
phone was also a public company and was listed on the
NYSE as well as the Frankfurt stock exchange. Wired
was a relatively small subsidiary of Wunderphone in
terms of revenue. With US$2 billion in annual revenue,
it represented less than 4% of Wunderphone’s total rev-
enue, which exceeded US$50 billion annually. How-
ever, Wired was important to Wunderphone because it
operated in an emerging market and had better earn-
ings growth potential than many of Wunderphone’s
larger subsidiaries, which operated in more mature
and more saturated markets.
Don, a US native, enjoyed living in Thailand and
working at Wired:
My job was exciting. Here I was, early in my career,
the CFO of a public company. I loved the people I
worked with. And the telephone industry was
dynamic. I had the opportunity to head up major
initiatives, such as debt refinancings and mergers
and acquisitions. It was fun.
Don was also involved in investor relations and spoke to
equity analysts from investment firms regularly about
Wired’s financial position and earnings trends.
Early in 2012, Don was working on the acquisition
of a wholesaler that bought cell phone minutes from
Wired and resold them to the public for a profit. Wired
management planned to integrate vertically so that the
company could bring the retail margins from cell
phone minute sales onto its income statement. This
acquisition would increase Wired’s revenues by
approximately 6%.
Steven Sarit, Wired’s CEO, asked Don to have
Wunderphone’s capital expenditure committee review
the acquisition proposal. This committee met often,
and it typically approved expenditures with minimal
administrative effort. If approved, then this transac-
Wired, PLC
tion could be accounted for as an ordinary capital
expenditure.
Don argued, however, that the proposed transaction
was a business acquisition. The proposal should be sub-
mitted to the mergers and acquisitions committee and,
if approved, it should be accounted for as a business
combination. He explained that the accounting rule
governing the transaction was IFRS Statement #3. If
Wired had planned to buy an asset that did not consti-
tute a business, such as a customer list, the asset pur-
chase could be treated as a capital expenditure. But
Wired planned to purchase assets constituting an
entire operating business. Further, the acquisition con-
tract specified that the transaction was to be a “busi-
ness” (rather than an asset) acquisition. If the
transaction were to be treated as an asset purchase,
under Thai law Wired would not assume the acquired
company’s customer contracts. Continuing the target’s
customer relationships after the acquisition was critical
to the success of the transaction.
But Steven was not ready to give up. He escalated
the issue to Philip Behrens, Wunderphone’s CFO. Philip
explained to Don that it was better for the company to
record the purchase as an ordinary capital expendi-
ture. The cell phone market had matured, and the
industry’s growth rate had stalled. Industry analysts
were scrutinizing earnings growth and trends closely.
Earnings derived from a business combination would
not be valued as favorably as “organic” growth. Philip
naturally wanted earnings to be valued as favorably as
possible. He told Don and Steven to find a way to “get
this done as an asset purchase.”
Steven was agreeable, but Don pushed back, argu-
ing that the transaction involved an earn-out, which he
maintained was almost impossible to reconcile with an
asset purchase. Still, Philip was sure that with a little
creativity, Don could work out a way to account for the
transaction as a capital expenditure. The conversation
became quite heated, and both parties finally agreed to
get an opinion from the accounting firm hired to assist
in the due diligence on the transaction. This firm
699
Chapter 15 • Management Control-Related Ethical Issues
agreed with Don, that they could not credibly classify
the transaction as an ordinary capital expenditure.
While he was relaying this news to Philip, Don
thought that he would add a practical constraint to the
argument. He told Philip that the finite amount of money
in the capital expenditure budget had either already
been spent or earmarked for real and necessary projects.
Philip thought that the budget issue was a minor hur-
dle that could be overcome and, unconvinced about Don’s
conclusion about the accounting treatment, Philip took
the accounting issue to the independent accounting firm
hired to audit Wired’s financial statements. The partner at
the auditing firm consulted his firm’s technical experts,
and they concluded that the issue was “gray.” Since the
This case was prepared by Research Assistant Michelle Spaulding and Professor Kenneth A. Merchant.
Copyright © by Kenneth A. Merchant.
CASE STUDY
Mean Screens USA, Inc.
Donna Stoneman was the CFO of Mean Screens USA,
Inc. Headquartered in Seattle, Mean Screens USA was
the sales and distribution division of Mean Screens,
Ltd., a privately owned Chinese company founded in
2007 that produced inexpensive LCD screens manufac-
tured in China for sale in the US market. By 2009, rapid
growth necessitated a significant infusion of capital. A
decision was made to spin off a portion of Mean Screens
USA in an IPO.
Since the beginning of the company, Donna had
worked together closely with Thomas Yee, Mean
Screens USA’s division president, to build the division.
She continued to play an instrumental role in the com-
pany’s subsidiary initial public offering (IPO) process,
travelling around the world to describe the investment
opportunity to potential investors.
However, Donna was troubled by the earnings pro-
jections that Thomas had instructed her to present. She
felt the forecast was extremely aggressive. She was
700
acquisition target was reselling minutes they had bought
directly from Wired, they thought that perhaps a theoreti-
cal argument could be made to support an asset purchase.
That was all Philip needed to hear. Philip told Don that
the debate was over. Philip was Don’s superior, and he
wanted the transaction treated as a capital expenditure.
He expected Don to figure out how to make it happen.
Don was at a crossroads. He believed the accounting
treatment was just plain wrong, and he did not want
any part of it, but his signature was required on the
fi nancial statements. He wondered if he could get in
trouble if the accounting was done as Philip wanted. He
was also worried that Philip would fire him if he contin-
ued to challenge him or if he refused to comply.
uncomfortable presenting numbers that she did not
think were realistic, and she was concerned that there
would be a backlash from investors if Mean Screens
USA failed to meet the projections. She expressed her
concerns to Thomas who agreed to lower the projec-
tions slightly, but he still kept them well above what
Donna believed was realistic.
Donna decided to accept Thomas’s revised numbers.
She felt she had done all she could, as she explained:
The earnings projections were not officially under
my jurisdiction. I really had no authority to change
them. And by definition forecasts are not black and
white. It was possible that Thomas’s numbers were
on target.
A successful IPO was launched in May 2009, and
Mean Screens USA, Inc. was listed on NASDAQ. Mean
Screens, Ltd. retained 51% of the public shares of the
subsidiary. In the fi rst fiscal year, however, as Donna

had feared, Mean Screens USA missed its profit projec-
tions by more than 30%.
Thomas was alarmed by the shortfall. He asked
Donna what they could do to increase earnings so that
the company’s fi nancial statements would mirror the
forecasts, and in this way pacify the new investors. His
fi rst idea was to deem some receivables as obviously
collectable to avoid setting up reserves. Donna thought
that the idea was ridiculous. She told Thomas that she
could not falsify fi nancial statements for any reason.
Thomas insisted that there was no falsification. The
setting up of reserves was a gray area of accounting
that depended on judgment. Donna explained that the
company was now public, and the audits would be
more thorough. The auditors would surely insist on the
establishment of reserves for uncollectible receivables.
Thomas was persuaded that perhaps this plan was
impractical, so he suggested another possibility. He
suggested that they postpone the writing off of
inventory that had likely become obsolete. Again,
Donna rebuffed his request.
Thomas was becoming increasingly angry at Don-
na’s refusal to work with him. He threatened her bonus
Tis case was prepared by Research Assistant Michelle Spaulding and Professor Kenneth A. Merchant.
Copyright © by Kenneth A. Merchant.
CASE STUDY
Lernout & Hauspie Speech Products
This case is a tragic blow not just for Belgium but also for
all of Europe. It shows how badly we need much greater
transparency and a sense of corporate governance. For too
long, banks and businesses did not feel they should be held
accountable to shareholders. That has to change.1
Philippe De Buck, Executive Director, Belgium
Federation of Industries
1
William Drozdiak, “Lost in the Translation; Voice-Recognition
Firm’s Failure Holds Painful Lesson for Europeans,” The Washington
Post (December 17, 2000).
Lernout & Hauspie Speech Products
and even told her that the long-term viability of the
company was at stake. Donna was sickened. She began
to wonder if Thomas was naïve or just unethical. She
was unwilling to sacrifice her own principles and integ-
rity, not to mention her CPA license, but she began to
fear that her job was on the line.
The reserves issues had still not been resolved when
Thomas came to Donna with a third request that he
hoped would appease his most important investors. He
wanted to ask the parent company for favorable trans-
fer prices for a year or so in order to shift some earn-
ings from the parent company to the subsidiary. He
would agree to reverse the favorability of the transfer
prices when Mean Screens USA could afford higher
prices.
Donna did not even know how to respond. Was Thomas
this ignorant about financial reporting requirements, or
was he just basically dishonest? If the latter, she had to con-
sider whether or not she wanted to work for someone who
was capable of such dishonesty. But she was also worried
about her bonus and, ultimately, her job. She had a family
to support, and with the country in a severe recession, it
would probably not be easy to find another job.
Mr. De Buck was referring to the demise of Lernout &
Hauspie Speech Products (L&H), which had been con-
sidered a world leader in speech-recognition technology
and one of Belgium’s most promising hi-tech compa-
nies. The company declared bankruptcy in October
2001 after the discovery of a massive accounting fraud
that implicated many L&H managers, including the top
management team. Like many others, Mr. De Buck won-
dered how this could have happened and what might be
done to avoid other scandals like this in the future.
701
Chapter 15 • Management Control-Related Ethical Issues
The company
The entrepreneurs
L&H was founded in 1987 when Jo Lernout, then a
sales executive with the Belgian arm of Wang Laborato-
ries, Inc., grew intrigued by an early Wang voice-mail
system. The system was not selling well because many
Europeans still had rotary phones and could not use
them to select amongst the voice-mail choices.
Mr. Lernout’s idea was to create software that allowed
users to make voice-mail selections by speaking into
the phone. He set up a company to commercialize
speech technology. Pol Hauspie, who owned a small
firm that made accounting software, joined him.
Belgium seemed a good location from which to operate
the company because the country was home to many
software engineers fluent in multiple languages. The
two partners based their company in Ieper, Belgium.
To finance the business, Mr. Hauspie sold his soft-
ware firm and Mr. Lernout sold his house. Mr. Lernout,
an ebullient chain-smoker with ruddy cheeks and a
mop of sandy-blond hair, recalled in an interview that
convincing his wife “was the hardest road show I’ve
had.” 2 The company barely survived several early
financial crises. At one point, it couldn’t make the pay-
roll and bailiffs came to seize property, Mr. Lernout
recalled. But he seemed to thrive on crisis. One of his
favorite sayings is, “The grass is always greener on the
other edge of the precipice.”3
Starting any new company is difficult, but two fac-
tors helped L&H survive in its early years. The first was
Belgium’s national pride. Like much of Europe, Belgium
envied America’s great hi-tech engine of wealth. And
now here were two guys with ambitions to turn a rural
corner of Flanders into a Silicon Valley of language
technology. In L&H’s early years, Flanders, Belgium’s
Dutch-speaking region, formed a tax-exempt zone in
Ieper – which gradually became known as the “Flanders
Language Valley” – and showered L&H with research
grants. The Flanders regional government became a
major L&H investor through a venture capital arm.
During one of L&H’s cash crunches, it guaranteed 75%
of a bank loan to the company. “Without that,”
Mr. Lernout says, “we would have gone broke.”4 Stefaan
2
Mark Maremont, Jesse Eisinger, and John Carreyrou, “Muffled
Voice: How High-Tech Dream at Lernout & Hauspie Crumbled in
Scandal,” The Wall Street Journal (December 7, 2000), p. A1.
3 6
Ibid.
4 7
Ibid.
702
Top, a Belgian venture capitalist, says the combination
of ambitious entrepreneurs and a government that
sorely wanted “a local tech champion was a combusti-
ble mix – it was dangerous.”5
The second was a series of complex financing plans
dreamed up by Mr. Hauspie. The taciturn former tax
accountant set up an intricate holding-company struc-
ture that let the founders retain control while selling
various minority interests. Devising such structures is
“Pol’s forte,” Mr. Lernout says. “He’s very creative.
Legally it’s all right, and it helps you survive.”6
In late 1995, the company went public with a listing
on the NASDAQ Stock Exchange, even though it had
never been profitable and had just a few million dollars
in annual revenue. As with many hi-tech firms, the
hope lay in a glittering future. “Natural speech inter-
face is the next technology wave,” one securities ana-
lyst wrote, “a potential multimillion dollar market.” 7
L&H’s managers dreamed of creating software that
would let computers effortlessly understand human
speech, speak back, and translate among the world’s
tongues.
The company seemed to face many challenges.
Technical development was painstakingly slow, as the
systems had to cope with many different accents and
speech patterns, not to mention the need to sort out
homonyms such as “wait” and “weight.” And industry
demand was sluggish. Many rivals struggled. One,
Kurzweil Applied Intelligence, Inc., in Massachusetts,
imploded after auditors found that its managers had
faked a large proportion of the company’s sales.
Another Massachusetts rival, Dragon Systems, Inc.,
eked out only slow growth in the mid-1990s. At L&H,
however, sales quadrupled in 1996 to $31 million.
Though some small acquisitions produced part of the
growth, L&H seemed to be relying on sales to custom-
ers with which it had financial ties.
Over the years, many of L&H’s customers received
investments from Flanders Language Valley Fund
(FLV Fund), a venture-capital pool that Mr. Lernout
and Mr. Hauspie helped create the year L&H went pub-
lic. Mr. Lernout and Mr. Hauspie were directors of the
fund’s management arm until 1997, and even after-
ward they maintained considerable sway over its
affairs. Michael Faherty, a former L&H salesman in the
United States, says he and others were encouraged to
5
Ibid.
Ibid.
Ibid.

refer potential customers who were cash-poor to the
FLV Fund. “If FLV invests $1 million in the customer,”
he says, “it was understood that we’d get about
$300,000” [in the form of license fees paid by that cus-
tomer to L&H].8 Though the FLV Fund denied financial
links between L&H and FLV, the close dealings between
the two were evident to some informed parties from
the start. In 1995, for example, FLV took a 49% stake in
the Belgian unit of Quarterdeck Corp., a high-flying
California software company. This Belgian unit became
L&H’s largest customer, accounting for 30% of revenue
that year, and Quarterdeck in California accounted for
another 6.5% of L&H’s sales.9
The CEO
In late 1996, Gaston Bastiaens was hired as L&H’s pres-
ident and CEO. Mr. Bastiaens was an engineer who led
the failed Newton project at Apple Computer, Inc. But
he flourished at L&H. Around the time Mr. Bastiaens
joined L&H, the company discovered a new and unu-
sual source of revenue: its own research-and-
development needs. This required an intricate
accounting maneuver, one that L&H had continued to
lean on throughout its tenure as a public company. L&H
knew it was trailing competitors in developing soft-
ware to recognize words spoken at an ordinary clip. “If
we didn’t catch up, we were cooked,” Mr. Lernout
recalled in an interview. “But we couldn’t catch up,
because we didn’t have enough R&D dollars.”10
The solution was to start a company and have it con-
tract with L&H to develop the software. L&H said it
gathered outside investors to fund the start-up, called
Dictation Consortium, NV. But L&H employees wrote its
business plan and did the software work under contract.
When the software was finished, L&H had an option to
buy the Dictation Consortium at a profit to the investors.
The arrangement ensured that L&H could claim to be
growing at a rapid pace. Dictation Consortium provided
L&H with $26.6 million in revenue in 1996 and 1997,
about one-quarter of its 1996 sales and 19% of its 1997
sales. Since Dictation Consortium bore the R&D costs,
they didn’t burden L&H’s bottom line. In 1998, L&H
bought Dictation Consortium for $40 million, gaining
control of the software it so badly wanted. Since
Dictation Consortium had few assets and almost the
8 11
Ibid.
9 12
Ibid.
10
Ibid.
Lernout & Hauspie Speech Products
entire price represented goodwill, it could be amortized
over seven years, further shielding L&H’s bottom line.
Buoyed by such deals and a spate of fresh acquisi-
tions, L&H’s revenue mushroomed to $211.16 million
in 1998, more than double 1997’s. The stock soared.
Mr. Lernout and Mr. Hauspie became entrepreneurial
celebrities, Belgium’s answer to Microsoft’s Bill Gates
and Paul Allen.
With the stock price up, Mr. Bastiaens bought technol-
ogy leaders such as Kurzweil Technologies, Inc., a speech-
recognition company in Wellesley Hills, Massachusetts,
and Mendez Translation Group of Brussels, Belgium. In
1997, a year after he came on board, Mr. Bastiaens landed
an important investor: Bill Gates. Microsoft invested $45
million in L&H, ending up with an 8% stake. The early
Microsoft investment gave L&H much needed credibility
and revenues. In 1999, Intel invested $30 million in L&H
and formed a venture with it to develop e-commerce and
telecommunications products.
Though all seemed well from the outside, internally
there were continuing glitches with L&H’s technology.
A 1998 presentation Mr. Lernout gave to French execu-
tives in Paris turned into a debacle when the software
failed to recognize many words, an L&H insider
recalled. “The bottom line was that the technology
wasn’t ready and the market wasn’t ready,” this person
says, “but management had to deliver every quarter.”11
Under Mr. Bastiaens, it did. L&H kept reporting growth.
Its sales rose 63% in 1999 to $344 million. Its Asian
sales exploded to more than $150 million from less
than $10 million in 1998. In March 1998, its stock hit
$72.50, up 2,500% from its initial offering price four
and a half years earlier.12
However, financial analysts had been suspicious of
L&H’s financial results as far back as 1997. In February
1997, Lehman Brothers’ Brian Skiba issued a report,
claiming that L&H’s growth in the United States and
Europe was much lower than investors had assumed, and
that the company was not coming clean. Mr. Bastiaens
denied it, but in a conference call, he refused to give a
geographic breakdown of sales.13 Still, investors ignored
financial analysts’ warnings and applauded the year-
2000 acquisitions of Dictaphone, based in Stratford, Con-
necticut, and Dragon Systems, of Newton, Massachusetts.
The future did, indeed, look bright. L&H seemed to have
Ibid.
Ibid.
13
Ibid.
703
Chapter 15 • Management Control-Related Ethical Issues
a lock on some of the best speech-recognition software,
and the company was powerfully positioned as the Web
migrated into phones and cars, where people would talk
to machines and machines would talk back. At the time,
Mr. Bastiaens assured anybody who would listen, “This
market is going to explode.”14 With the purchase of the
company’s two main US rivals, L&H was suddenly a soft-
ware company with $1 billion in annual sales, and it was
poised to follow SAP and Nokia Corp. into Europe’s tech-
nology elite.
The Dictaphone purchase, however, meant more
than half of L&H’s business was in the United States.
This obliged the company to file detailed accounts with
the SEC. Analysts learned that sales in Korea had
soared from a mere $97,000 in 1998 to $58.9 million in
the first quarter of 2000, some 52% of the total sales of
the company. Suspecting an attempt to pump up
results, investors began to dump the stock in 2000.15
The Wall Street Journal report
In August 2000, The Wall Street Journal reported that
some Korean companies L&H described as customers
denied doing business with it, while some others said
they had bought less than L&H said they had:
In all, the Journal contacted 18 of about 30 compa-
nies claimed by L&H as customers. Three of the
companies said they weren’t, in fact, L&H custom-
ers … Three more companies said their purchases
from L&H over the past three quarters were smaller
than figures provided by Mr. Bastiaens or Sam Cho,
vice president of L&H Korea. One additional com-
pany said it is in a joint business with L&H that pro-
duces considerably less revenue than L&H claims.
Officials from an eighth company initially said it had
formed a joint venture with L&H and that the joint
venture, not the company itself, had purchased
products from L&H…
Of the other 10 companies, three confirmed they
were customers but wouldn’t give the size or timing
of their purchases. Officials at another six con-
firmed total purchases totaling $450,000 to
$5.5 million in the period since [September 1999].
One company says it signed a $10 million contract
with L&H and paid in May 2000.
14
William Echikson and Ihlwan Moon, “How to Spook Investors,”
Business Week (September 18, 2000), pp. 69–72.
15
Ibid.
704
All told, of the 12 companies that responded to
inquiries about their purchases from L&H in the
period since [September 1999], the revenue tallied
roughly $32 million. From all of its customers in
Korea, in 1999 and the first quarter of 2000, L&H
posted $121.8 million of Korea sales, and it had said
that it expected second-quarter revenue from that
country to exceed the first quarter’s $58.9 million.16
L&H responded with a statement saying that com-
ments attributed to L&H customers were “misquoted or
factually incorrect” and that other information in the
article was “distorted.”17 To buttress its case, L&H com-
missioned a mid-year audit by KPMG.
After the Korea scandal broke, Mr. Bastiaens rushed
to restore confidence. He contacted several of the Korean
customers interviewed for the Journal story, and they
publicly said they were misquoted. A trip to Korea was
arranged for two financial analysts, both of whom were
impressed with the company’s business there. “I met cus-
tomers and saw L&H products really being used,” says
Kurt Janssens of KBC Securities in Brussels.18 Most
important, Mr. Bastiaens asked for the KPMG special
audit. “He wouldn’t be so stupid as to ask for an audit if
he had something to hide,” says Pierre-Paul Verelst, an
analyst at Brussels brokers Vermeulen Raemdonck.19
By this time, founders Lernout and Hauspie thought
Mr. Bastiaens had become a liability. On August 25,
2000, he was replaced with John Duerden, a British-
born US citizen who had worked at Xerox Corp. and
Reebok International, Ltd., before running Dicta-
phone.20 In November 2000, L&H admitted for the first
time that “mistakes and irregularities” had slipped into
the annual accounts. Mr. Hauspie resigned as an officer,
and in March 2001, Mr. Lernout was dismissed. In
November 2000, L&H filed for bankruptcy protection.21
Discovery of a massive fraud
In January 2001, Philippe Bodson replaced Mr. Duerden
as L&H’s chief executive, and PricewaterhouseCoopers
16
Mark Maremont, Jesse Eisinger, and Meeyoung Song, “Tech Firm’s
Korean Growth Raises Eyebrows,” The Wall Street Journal (August
8, 2000), p. C1.
17
Mark Maremont, “Lernout & Hauspie Shares Fall 19% as It Attacks
Article,” The Wall Street Journal (August 9, 2000), p. A16.
18
Echikson and Moon, “How to Spook Investors.”
19
Ibid.
20
Ibid.
21
“Dossier Lernout en Hauspie,” De Standaard (January 2011), online
at www.standaard.be.

(PwC) was brought in for an investigation. The PwC
report was released on April 6, 2001. It revealed that 70%
of the nearly $160 million in sales booked by L&H’s
Korean unit between September 1999 and June 2000
were fictitious. In an effort to earn rich bonuses tied to
sales targets, the Korean unit’s managers developed
highly sophisticated schemes to fool L&H’s regular audi-
tor, KPMG International. One especially egregious
method involved funneling bank loans through third
parties to make it look as though customers had paid
when in fact they had not.
L&H’s new chief executive, Philippe Bodson, said
that upon learning of PwC’s findings he “was very
impressed by the level of sophistication” of the fraud
and “the amount of imagination that went into it.”22
To fool auditors, L&H Korea used two types of
schemes. The first involved factoring unpaid receiva-
bles to banks to obtain cash up front. Side letters that
were concealed from KPMG gave the banks the right to
take the money back if they couldn’t collect from L&H
Korea’s customers. Hence, the factoring agreements
amounted to little more than loans.
The second, more creative scheme was set in motion
after auditors questioned why L&H Korea wasn’t col-
lecting more of its overdue bills from customers. L&H
Korea told many customers to transfer their contracts
to third parties. The third parties then took out bank
loans, for which L&H Korea provided collateral, and
then “paid” the overdue bills to L&H Korea using the
borrowed money. The upshot is that L&H Korea was
paying itself. When the contracts were later cancelled,
L&H Korea paid “penalties” to the customers and the
third parties to compensate them “for the inconven-
ience of dealing with the auditors.”23
The probe also found that the bulk of L&H Korea’s
sales came from contracts signed at the end of quarters,
so managers could meet ambitious quarterly sales targets
and receive large bonuses. For instance, 90% of the reve-
nue recorded by L&H Korea in the second quarter of 2000
was booked in 30 deals signed in the final nine days of the
quarter. But L&H Korea was forced to subsequently can-
cel 21 of those contracts because the customers – most of
them tiny start-ups – didn’t have the means to pay.
The fraud appears to have begun in earnest when
L&H bought a small Korean firm called Bumil Informa-
tion & Communication Co. in September 1999 and put
22
John Carreyrou, “Lernout Unit Book Fictitious Sales, Says Probe,”
The Wall Street Journal (April 9, 2001), p. B2.
23
Ibid.
Lernout & Hauspie Speech Products
Bumil’s management, headed by Joo Chul Seo, in
charge of L&H Korea. L&H Korea, which had been
reporting negligible sales until then, recorded nearly
$160 million in license revenue between the time
Bumil was acquired and June 30, 2000. Mr. Seo made
$25 million from the sale of Bumil to L&H and earned
another $25 million in bonuses for meeting sales tar-
gets while at the head of L&H Korea.24
Where were the auditors?
In the aftermath of the accounting scandal at L&H,
angry investors turned their gaze on KPMG Interna-
tional, the giant accounting firm that audited L&H’s
books and gave the company clean opinions in 1998
and 1999. KPMG also gave a clean 1999 opinion regard-
ing the accounting for L&H’s South Korean operations,
where sales had grown improbably to $62.8 million
from just $245,000 in the previous year. Michael G.
Lange, a partner at a Boston law firm that was leading
one of the shareholder lawsuits seeking class-action
status against L&H, said that the accounting irregulari-
ties at L&H “were so pervasive and included so many
aspects of the business” that “there had to be red flags”
that KPMG auditors missed.25
KPMG, in its defense, accused the former top man-
agement of L&H of signing off on revenue over-inflation
tactics, of lying about key business structures within the
company, of influencing others to give false information
to KPMG auditors, and of orchestrating a campaign to
minimize their involvement in the events that had led to
the calamitous downfall of the company. In April 2001,
a few hours before the release of an abridged version of
PwC’s report, KPMG filed a lawsuit against L&H’s for-
mer management in a Belgian court. The complaint
alleged that former senior L&H executives “deliber-
ately” provided “false or incomplete information” to
KPMG and conspired to obstruct the firm’s audits.26
In its complaint, KPMG said that L&H’s former top
management “was fully aware and actively involved in
the irregularities and that these people have wittingly
given false information to KPMG.”27 KPMG alleged that
24
Ibid. According to the PwC report, investigators have been unable
to track down Mr. Seo since L&H fired him in November 2000.
Mr. Bodson said Mr. Seo was last spotted in China.
25
Mark Maremont, “KPMG, Former Auditor of L&H, May Draw
Investor Ire,” The Wall Street Journal (January 18, 2001).
26
Robert Conlin, “KPMG: Lernout & Hauspie Top Management Lied,”
www.CRMDaily.com (May 11, 2001).
27
Ibid.
705
Chapter 15 • Management Control-Related Ethical Issues
Mr. Hauspie was implicated in a scheme to illegally
raise money for a fund he participated in. The scheme
involved a complex web of Korean banks, L&H subsidi-
aries, and Joo Chul Seo, the company’s former head of
Korean operations. KPMG also alleged that the com-
pany co-founder Jo Lernout, at the very least, partici-
pated in the campaign to conceal information from its
auditors.
In addition, KPMG commented that the practice of
inflating revenues was a common one at L&H. “After-
wards [referring to a period in 1999] it appeared that
the antedating of contracts to increase the turnover of
the relevant quarter was common practice,” said the
KPMG report. 28 “The company, on a regular basis,
increased its turnover of a particular year or quarter by
means of various kinds of irregularities.”29
The aftermath
In April 2001, Mr. Lernout and Mr. Hauspie were
arrested in Belgium and placed under custody for nine
weeks on charges of forgery and market manipulation.
The arrests came after a new round of audits uncovered
an additional $96 million in fictitious sales, which
brought the tally of fake sales from early 1998 to mid-
2000 to $373 million, or 45% of reported revenue.30
L&H was declared bankrupt in October 2001 after
the commercial court in Belgium rejected the compa-
ny’s request for bankruptcy protection. US-based Scan-
soft purchased the speech technology and kept some
28
Ibid.
29
Ibid.
30
John Carreyrou, “Lernout & Hauspie Figures Are Arrested,” The
Wall Street Journal (April 30, 2001).
31
Mark Maremont, “KPMG to Settle Suit over Audit of Lernout,” The
Wall Street Journal (October 8, 2004).
706
L&H personnel in employ, but the name L&H was axed.
KPMG and its Belgian affiliate settled a lawsuit for
$115 million brought against it by shareholders. KPMG
stated that they settled to avoid a protracted legal trial,
and maintained that they had acted appropriately in
their audit of L&H at all times.31 The court hearings
started in May 2007 against Mr. Lernout, Mr. Hauspie,
and 19 others, including former senior corporate and
subsidiary managers. In September 2010, a Belgian
court found the company’s co-founders, Mr. Hauspie
and Mr. Lernout, as well as former CEO Bastiaens and
another senior manager, guilty on various charges
relating to financial fraud, including falsification of
annual accounts, forgery, and market manipulation.
Mr. Hauspie, Mr. Lernout, and the senior manager were
all sentenced to five years in prison, of which three
years effective and two years probationary. Mr. Basti-
aens was sentenced to two years effective imprison-
ment. Under Belgian prison terms, however, they were
unlikely to have to clock any jail time.32
While KPMG was cleared, its partner responsible for
the accounting supervision at L&H was fined €2,478.93.
The court declared that the professional fault held
against him was not intentional, but he was found
guilty of negligence.33
These charges, however, covered the criminal liabil-
ity of those involved in the company’s fraud only. The
question of compensation was to be tackled in pending
civil proceedings, which were slated to start by the end
of 2011.34
32
Charles Forelle, “Lernout Founders Guilty of Fraud,” The Wall Street
Journal (September 2, 2010), p. B1; Mark Eeckhaut, “L&H-Toplui
Wellicht Nooit Naar de Cel,” De Standaard (September 22, 2010);
www.deminor.com (September 23, 2010).
33
www.deminor.com (September 23, 2010).
34
Ibid.
 Lernout & Hauspie Speech Products

Appendix 1 Appendix to the August 8, 2000 The Wall Street Journal report

A Kick from Korea

Lernout & Hauspie’s sales by region or country for the three months ended March 31, 2000 ($000). The company’s
South Korean business soared after an acquisition in September 1999.

1999 2000

Europe (excluding Belgium) 22,435 19,748

United States 20,154 19,939

Belgium 14,739 9,178

Singapore 10,430 501

Other Far East 2,853 2,396

South Korea 97 58,932

Source: The Wall Street Journal (August 8, 2000), p. C1.

Appendix 2 10 steps to Chapter 11

A Lernout & Hauspie chronology

June 30, 2000 L&H reveals that nearly all of its overall growth in recent quarters came from South Korea and
Singaporean business.

Aug. 8, 2000 The Wall Street Journal reports that some Korean customers claimed by Lernout & Hauspie do no
business with the company. Others said their purchases were smaller than L&H reported.

Aug. 25, 2000 CEO Gaston Bastiaens steps down; former Dictaphone CEO John Duerden steps in. The company’s
stock falls 9% to $31.

Sept. 20, 2000 The SEC launches a formal investigation of L&H’s accounting practices.

Sept. 22, 2000 The Wall Street Journal reveals that 25% of L&H’s 1999 revenue came from start-up companies
that it helped create.

Sept. 25, 2000 Europe’s Easdaq launches a formal investigation into L&H.

Sept. 27, 2000 L&H issues a profit warning for the third quarter.

Nov. 9, 2000 L&H says it will revise financial statements for 1998, 1999, and the first half of 2000 to make up for
past accounting “errors and irregularities”; co-chairmen Jo Lernout and Pol Hauspie resign their
executive posts; trading of L&H stock is suspended.

Nov. 16, 2000 The company’s accounting firm KPMG International withdraws its audits of 1998 and 1999 results.

Nov. 29, 2000 L&H files for Chapter 11 bankruptcy protection along with its Dictaphone unit, after $100 million is
discovered missing in the firm’s South Korean unit.

Source: The Wall Street Journal (November 30, 2000), p. A3.

707
Chapter 15 • Management Control-Related Ethical Issues

Appendix 3 Accounting for auditing problems – recent large settlements paid by auditors

Settlement amount
Auditor Company audited Year Allegations ($ millions)

Ernst & Young Cendant 1999 Inflated revenue, understated expenses $335

Ernst & Young Informix 1999 Inflated revenue $34

Arthur Anderson Waste 1998 Overstated assets and other accounting $75
Management problems

Coopers & Centennial 1998 Bogus sales $20

Lybrand* Technologies

*Now part of PwC.

Source: The Wall Street Journal (January 18, 2001), p. C1.

This case was prepared by Professors Kenneth A. Merchant, Wim A. Van der Stede, and research assistant Xiaoling (Clara)
Chen. The case was revised with the help of Professor Martine Cools.
Copyright © by Kenneth A. Merchant and Wim A. Van der Stede.

CASE STUDY
Ethics@Cisco

A strong commitment to ethics is critical to our long-
term success as a company. The message for each
employee is clear: any success that is not achieved ethi-
cally is no success at all. At Cisco, we hold ourselves to
the highest ethical standards, and we will not tolerate
anything less.
—John Chambers, CEO, Cisco Systems, Inc.1
Cisco Systems, Inc. (Cisco), a large, multinational
networking technology company headquartered in
San Jose, California, won multiple awards for its
ethics program, known internally as Ethics@Cisco.
For example, as it had each year since 2008, Cisco
was honored in 2012 as one of the World’s Most Ethi-
cal (WME) companies by the Ethisphere Institute,
an international think-tank dedicated to the crea-
1
http://www.cisco.com/web/about/citizenship/ethics/index.html
tion, advancement and sharing of best practices in
business ethics and corporate social responsibility.
The Ethisphere website explained that the WME
designation “recognizes companies that truly go
beyond making statements about doing business
“ethically” and translate those words into action.”
Similarly, Cisco’s program was named in both 2009
and 2010 by Corporate Secretary magazine as the
“The Best Overall Governance, Compliance and Eth-
ics Program” in the large-capitalizationcompany
category.
Phil Roush (Vice President – Governance, Risk and
Controls) explained that Cisco’s ethics program
… not only demonstrates the Company’s effort to
be a good corporate citizen, it also provides a com-
petitive advantage. It signals to potential custom-
ers how seriously we take ethical conduct, and it
translates into how Cisco approaches all of our
internal and external interactions.

708

Company background
Cisco was the world leader in networking technology
for the Internet. The company designed, manufac-
tured, and marketed a broad range of Internet Protocol
(IP)-based networking and other related products and
services primarily to customers in the communications
and information technology industries located around
the world. The company’s diverse product portfolio
included storage, web conferencing, routing, digital
video, wireless, switching, and voice technology. Cisco
had a significant market share in each of its product
categories. The company distributed and sold its prod-
ucts through a large network of channel partners and
resellers.
Cisco was founded in 1984 by a married couple, two
scientists from Stanford who invented the multi-proto-
col router so they could send messages to each other
from separate office buildings. Ever since then, the
company’s focus had been “connecting lives.” The com-
pany’s stock became publicly traded on February 16,
1990.
Cisco’s growth was rapid. In fiscal year 2011 (ended
July 31, 2011), the Company had annual revenues
exceeding $43 billion (see Exhibit 1), and it employed
approximately 65,000 people in almost 500 different
offices in over 165 countries. Cisco spent over $5 billion –
roughly 13% of its revenue – on R&D. Its workforce was
highly educated: one-third of the employees were engi-
neers, and another onethird were in sales.
The Cisco culture emphasized open communication,
innovation, and trust. Phil Roush explained,
When I joined Cisco, many executives indicated
that this is a company that is built for speed and
that we have a high-trust environment. John Cham-
bers [CEO] often refers to the employees as being
part of the Cisco family. But in a family of 65,000
co-workers you’re going to have some issues arise.
You better have some rules, and some accountabil-
ity, that help facilitate the speed and high-trust
environment. Proper governance processes can
actually assist a company in moving more rapidly.
Ethics@Cisco
The Ethics@Cisco program was designed to ensure
that all Cisco employees adhere to a very high standard
of business and professional conduct. Cisco had only
one ethics policy that was applied globally.
Ethics@Cisco
The company, however, faced some quite unique
and difficult challenges in attaining its compliance and
ethics goals. Cisco was a large company with a rela-
tively young workforce with many different cultural
norms and languages. Cisco continued to grow rapidly,
and much of the company’s growth came from acquisi-
tions. Since 2000, Cisco had acquired 105 companies,
all of which had to be assimilated into Cisco’s culture
and processes. As a hi-tech firm operating in a dynamic
environment, the company had a “freewheeling spirit”
that sometimes needs to be reined in. Perhaps not sur-
prising for a networking company, 85% of Cisco’s work-
force worked “virtually,” regularly working from home
or on the road. And much of the Cisco business was sold
through channel partners in over 180 countries who
were regularly presented with a wide variety of gift
giving and receiving conundrums on a regular basis.
The partners also presented a challenge in that their
actions were more difficult to monitor than were those
of employees.
The three core elements of the Ethics@Cisco pro-
gram were (1) a Code of Business Conduct (COBC);
(2) an extensive employee awareness, training and
certification program; and (3) internal investigations.
These are described below.
Cisco’s ethics program was over 15 years old. Previ-
ously the program was administered by the Human
Resources (HR) department. In 2005, a dedicated,
three-person Ethics Office assumed responsibility for
this function. In 2012, this office was composed of sen-
ior manager Jeremy Wilson, program manager Joel
Mark, and marketing communications manager Ruth
Savolaine. The Ethics Office’s mandate was to drive
awareness of Cisco’s ethics policies.
In its early years, the Ethics Office reported to
Human Resources. In 2008, it became part of Govern-
ance, Risk and Controls, which reported to the Finance
department. In August 2012, the Ethics Office was
moved to become part of a new centralized Compliance
department reporting to Cisco’s General Counsel.
According to Cisco’s benchmarking studies, this latest
reporting structure was consistent with best practices
across publicly held companies. The General Counsel
had the oversight on driving the ethics programs and
policies.
The Code of Business Conduct
The cornerstone of the Ethics@Cisco program was a
Code of Business Conduct (COBC). 2 The COBC was
709
Chapter 15 • Management Control-Related Ethical Issues
designed to help every Cisco employee understand how
to make ethical decisions that were consistent with the
company’s values as well as with applicable laws and
regulations. The core company values underlying the
COBC were integrity, respect, open communication,
social responsibility, diversity, and empowerment.
Among the specific topics covered in the COBC were
sharing concerns, respecting others, using resources
responsibly, avoiding conflicts of interest, understand-
ing gift and entertainment policies, protecting Cisco
assets, following the law, and adhering to internal
financial and accounting policies. The COBC included
some specific policies, such as the requirement of pre-
approvals for the giving and receiving of gifts valued at
US$100 or more, but it also included many more gen-
eral decision-making principles. The wording in the
COBC was mostly general, but it was supported by
detailed policies in some areas of activity. The COBC
was published in English and 12 other languages.
To make the COBC easily understandable, with low
use of jargon, the key principles necessary to demon-
strate the company’s commitment to integrity were
summarized in the COBC in ten “I statements” (see
Exhibit 2).
The COBC also included an ethics decision tree that
was designed to help employees think through difficult
ethical issues (see Exhibit 3). The decision tree helped
employees find laws and policies that might apply in
the situation they are facing and to ask important ques-
tions and/or seek guidance from managers, the Ethics
Office, or the legal department before they take action.
Financial employees had an additional Code of Con-
duct that included more specific financial reporting
guidelines and a requirement to be a role model of ethi-
cal behavior (see Exhibit 4).
Prior to 2007, the COBC was a static document writ-
ten in legal terms that could be challenging for a non-
lawyer to understand and apply to real life situations.
Between 2009 and 2011, the ethics team completely
overhauled the document with the goal of bringing the
COBC “to life.” They shortened it, made it more reada-
ble, and added more color and graphics. They replaced
legal jargon with text written at a more elementary
reading level. They also included practical “what if”
examples to make the COBC more relevant to the issues
employees faced every day (see Exhibit 5).
2
The complete document is shown at http://files.shareholder.com/
downloads/CSCO/2047645290x0x563236/f8c558b8-11dd-4f32-
89cd-7b9da77895d1/Cisco_Code_of_Business_Conduct_FY12.pdf
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In 2012, the Ethics Office team brought the COBC
onto an online portal and made it into an interactive
eBook, with pages that appeared to turn, intuitive pop-
ups, embedded videos, and purposeful animation.
Employees were able to ask questions and engage in a
two-way dialogue with experts on the ethics team.
They could also disclose gifts and potential conflicts of
interest using an online reporting tool. The team hoped
that with these changes employees would view the
COBC as a practical reference tool that could be used
whenever they faced an ethical issue.
Ethics awareness, training,
and certifications
Cisco used many methods to help ensure that all
employees (and partners and agents) were aware of,
and understood, the COBC. These included electronic
display boards, websites, a management portal, a dis-
cussion forum, and various forms of training.
Most companies’ ethics training is live, but most all
of Cisco’s training was done online, due to the compa-
ny’s highly virtual workforce. Annually, employees
were required to go through interactive training that
took about 20 minutes. They answered ethics questions
using the COBC as a reference and received instant
feedback if they answered assessment questions incor-
rectly. The training also included two brief videos that
used humor to communicate two key messages: (1) the
COBC is robust and easy to use, and (2) there are sev-
eral ways to get ethics assistance at Cisco. These videos
were shown with subtitles for employees whose native
language was not English.
In 2012, the videos received positive employee feed-
back, with 87% of employees reporting that the videos
enhanced or somewhat enhanced their understanding
of the COBC and the resources available to them. One
of the training videos, an ethical-mindset video aimed
at new managers, won a Gold Medal in 2011 from the
New York Festivals International TV & Film Awards® in
the category Internal Use Training Videos.
On request, the Ethics Office developed targeted,
job-specific training for individual business units. For
example, a five-minute anti-bribery video was pro-
duced specifically for employees who interacted with
government officials. Other targeted training videos
focused on conflicts of interest, ethics for sales associ-
ates, new hires, new managers, antitrust, and anticor-
ruption. These topic- and role-specific videos were very
targeted and short, because it was known that most

people’s attention spans are short, and resistance to
training increases sharply after about 10 minutes. The
videos explained where additional information could
be found. The Ethics Office also ran special awareness
campaigns, such as an end-of year campaign reiterat-
ing the company’s gift policies.
Annually, all Cisco employees were required to certify
that they had reviewed, understood, and agreed to abide
by the COBC. Certification was a condition of employ-
ment, and failure to sign the certification document pro-
vided grounds for corrective action, up to and including
termination of employment where permissible by law.
Before 2009, the COBC certification was not manda-
tory. In 2009, however, the ethics team obtained a
mandate from the Audit Committee to have all employ-
ees sign the certification annually going forward. Per-
sonnel in the Ethics Office and department managers
used Ethics Connect, a proprietary tool that provided
instruction, created records of employees who had
signed the COBC and agreed to abide by it, and sent tar-
geted email messages to those who had not yet fulfilled
their certification obligation. After a five-week cam-
paign ending in early June, COBC certifications were
received from 100% of Cisco employees.
Initially there was some resistance to the certifica-
tion requirement, not because the content of the COBC
was objectionable, but because the idea of something
being mandatory was a cultural shift. This was one of
Cisco’s first global mandates. Jeremy Wilson (Ethics
Office manager) explained that, “The last one percent
(600–700 people) created a bit of a challenge as they
were not familiar with the process.”
Tone from the top also played a large part in driving
ethical behavior. Prat Bhatt (Corporate Controller)
reflected,
Training has a positive impact, but the effects are
short-lived. Some people think that training is a
check-the-box exercise that everyone has to do. Con-
trols and processes can be circumvented. If you don’t
have the tone and culture to support ethics, with pub-
lic hangings for wrong-doing and recognition for
doing the right things, the rest is superficial. What I’ve
found unique about Cisco is the culture and the tone,
which is set from all the way at the top with the CEO.
Internal investigations
A 24-person Internal Investigation group also reported
to the Compliance department. Sixteen members of the
group were investigators responsible for investigating
Ethics@Cisco
employee fraud. These investigators had backgrounds
in accounting, auditing, and law enforcement. The
cases they investigated ranged from expense fraud to
deal manipulation, diversion, and corruption.
Approximately 100 investigation cases were open in
a typical quarter, but on average only about 10% of
those cases were actionable. Many cases were initiated
in the employee online incident reporting tool. Some
reports were malicious, such as occurred when vendors
“threw mud at each other.” Sometimes reports were
valid, but they were not supported with strong enough
evidence to warrant disciplinary action. In those
instances, the internal investigations personnel
attempted to get more details from the whistle-blower.
Even if they were not able to prove wrongdoing, they
could use the incident to evaluate and perhaps improve
internal controls. Many cases were identified as a result
of Sarbanes-Oxley (SOX) control testing. For example,
one expense audit uncovered a $200,000 expense
fraud scheme that was successfully investigated. An
employee had found a way to log in as her boss to
approve her own expense reimbursements.
When Internal Investigations were able to substanti-
ate that there had been an infraction of the COBC or
local laws, employees were disciplined. If theft was
involved, Internal Investigations made an attempt to
obtain voluntary restitution from the employee rather
than involving outside law enforcement. Depending on
the infraction, employees could be terminated or
receive verbal and written warnings. In order to avoid
unfair termination lawsuits in the United States, Cisco
employees were only terminated if they violated a spe-
cific, published policy. Written warnings provided use-
ful documentation should a second infraction be
committed. In other countries it could be even more dif-
ficult to legally terminate employees because of strong
labor protection laws. Typically, very few employees
were terminated for policy violations or other improper
actions. All incidences of fraud were reported to the
Audit Committee, even if the infraction was committed
by someone below the Vice President level.
Sarbanes-Oxley compliance
Cisco relied on strong SOX compliance teams to ensure
ethical behavior in some important areas of activity,
including financial reporting, antitrust, bribery, and
insider trading. Kristin White headed a team of 18 pro-
fessionals responsible for financial and business pro-
cess controls, reporting to Prat Bhatt (Corporate
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Chapter 15 • Management Control-Related Ethical Issues
Controller). The Information Technology (IT) organi-
zation owned its own SOX controls and had its own
18-member team, reporting to the Chief Information
Officer (CIO) of IT/Risk Management. These teams
were responsible for understanding the US SOX
requirements and SOX-like requirements in other
countries, and they strove to maintain consistent con-
trols internationally. These teams partnered heavily,
and monitored the effectiveness of almost 1,000 key
controls. In addition to performing standard SOX
duties, the SOX compliance teams made sure that con-
trols were in place in companies that Cisco acquired, in
new project venture areas, and in international expan-
sion initiatives.
According to Kristin, working on SOX was reward-
ing at Cisco because of the company’s strong ethics.
“Cisco has embraced SOX compliance,” she explained.
“It’s part of the DNA of the company, and it is highly vis-
ible.” According to Kristin, John Chambers, the CEO of
Cisco, took controls very seriously. He was committed
to spending quality time reviewing the information
and processes to ensure accuracy and adequacy of their
public reporting, and he expected his senior managers
to highlight issues and let him know if they had any
concerns.
Operation of the System
The Ethics@Cisco system encouraged employees who
were unsure as to how to act in any circumstance to
escalate questions to higher levels of management
without fear of repercussion. Difficult ethical questions
were often escalated all the way to the General Coun-
sel. Van Dang (Senior Vice President, Regulatory and
Compliance), explained:
There is an escalation process. People opinion
shop. If they don’t get the answer they like and they
don’t agree, they go up the chain and appeal to
higher levels of management because lower level
managers are less likely to take risks. In some com-
panies if you escalate you lose your job, but not at
Cisco. It’s a very open company. Employees can go
directly to a higher-level manager.
If employees did not want to get talk with someone
in the management hierarchy to get advice on an ethi-
cal issue and/or to report a potential problem, they had
several other options. They could correspond with per-
sonnel in the Ethics Office or use an email alias that
sent a message directly to the Audit Committee of the
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Board of Directors, an anonymous online incident
reporting tool, or a multilingual telephone hotline.
More than 84% of reports and questions came through
email or online sources, with more than 60% being
handled by the Ethics Office directly.
The number of ethics calls made at Cisco had been
fairly stable at approximately 100–150 calls per quarter.
The total number of calls was aligned with those at other
hi-tech companies, at less than 1% of the workforce size.
Of the calls made, more raised questions (60%) than
allegations (40%). The top five call categories were:
1. Policy Issues (policy interpretation/application)
2. Employee Relations (harassment, intimidation, dis-
crimination)
3. Conflicts of Interest – general
4. Conflicts of Interest – gifts
5. Conflicts of Interest – personal relationships
Financial reporting breaches were alleged less than
once per year.
The ethical issues raised tended to spike around
times of training, annual certification, and special
events. For example, Cisco was the technology sponsor
of the 2012 London Olympics, so Cisco employees
fielded many requests for tickets or special event
access, and questions arose. After the ethics team intro-
duced a video showing an employee reporting a second
job, there was a 700% increase in disclosures of outside
jobs. Cisco had also developed an online disclosure tool
to automate the exception-approval process.
The COBC made it very clear that retaliation against
whistle-blowers would not be tolerated. The culture at
Cisco also supported open discussion, as evidenced by
the fact that 82% of people who reported ethics violations
or asked ethics questions chose to identify themselves.
Cisco was trying to automate some portions of the
control processes. For example, they were considering
flagging some forms of reimbursements for an auto-
matic review.
An example: gift acceptances
Most of the guidelines in the COBC were derived from
Cisco’s values. It was not possible to provide specific
rules for every type of situation that might be encoun-
tered. The guidelines needed to be interpreted and
applied to the specific situations faced. Acceptable
behaviors in areas presenting frequent or serious risks
were spelled out in more detail.

For example, employees’ accepting gifts from
suppliers was a common risk area. It was known that
in the past some employees had not reported gifts
they had received, and some had even sold them on
eBay.
The gift-acceptance guidelines explained in the
COBC were:
● Have no obligation or expectations (stated or
implied)
● Be made openly
● Have reasonable value, defined as less than US$100
per source per year
● Conform to the giver/reviewer’s rules
● Be appropriate, legal and accurately documented.
Any exception had to be approved in writing by the Eth-
ics Office. Some gifts could require approvals from a
Vice President in the relevant organization or a Human
Resources (HR) manager.
With inquiries about gift acceptances, there were
three plausible answers: (1) acceptable, (2) unaccepta-
ble (the gift must be returned), or (3) the gift may be
accepted, but the employee must turn it over to Cisco for
public display or donation. Those approving the requests
tried to adhere to the COBC guidelines while also trying
to allow for reasonable special circumstances.
The multiple channels for grants of exceptions made
ethics feedback easily accessible, but could occasion-
ally cause confusion. In one instance, a supplier gave a
watch to 200 people in the same department. Only six
of those 200 employees asked permission to accept the
gift, but because some asked the Ethics Office, some
asked HR, and some asked the Vice President in their
own organization, they received three different
answers. When these discrepancies were discovered,
follow-up meetings were held to provide a better
Ethics@Cisco
understanding of the process and to implement a uni-
form approach.
Evidence of effectiveness
Annually, Cisco conducted an internal survey of all
65,000+ employees to get feedback on key aspects of
the Company’s culture. Results from the 2012 survey
reflected well on the ethics program (see Exhibit 6).
Among other things, on this survey 91% of the employ-
ees reported that they were confident that Cisco took
ethical business concerns seriously.
Overall, there was a strong sense of pride in Cisco’s
ethics program. Phil Roush observed:
It starts with the well-defined “tone at the top” on
the expectations of ethical conduct of Cisco’s
employee base. From those expectations, it cas-
cades out to all of the Company on our approach to
business and how we deal with the inevitable ques-
tions and unique situations that arise when you do
business in over 100 countries.
We still have opportunities to raise awareness
across a very diverse and geographically dispersed
population. Plus, there are always new questions
and concerns that do come up, for example how to
consistently address the various forms of social
media that are prevalent today. We want our
employees to embrace the new technology that is
available, but do it in a way that does not expose
the Company to negative consequences.
If we do meet with the SEC [U.S. Securities and
Exchange Commission] or the DOJ [U.S. Depart-
ment of Justice], and they inquire about Cisco’s
Ethics program – we feel that there are many proof
points of how seriously we take the expectations
on ethical behavior. No company will likely be per-
fect, but I am confident Cisco has a strong process.
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Chapter 15 • Management Control-Related Ethical Issues

Exhibit 1 Cisco Systems, Inc., income statements (2010–2012)

FY 2012 Year Ended FY2011 Year Ended FY2010 Year Ended

(In millions, except per-share amounts) July 28, 2012 July 30, 2011 July 31, 2010

NET SALES:
Product $ 36,326 $ 34,526 $ 32,420
Service 9,735 8,692 7,620
Total net sales 46,061 43,218 40,040

COST OF SALES:
Product (a), (b) & (d) 14,505 13,647 11,620
Service (a) 3,347 3,035 2,777
Total cost of sales (a), (b) & (d) 17,852 16,682 14,397
GROSS MARGIN (a), (b) & (d) 28,209 26,536 25,643

OPERATING EXPENSES:
Research and development (a) & (c) 5,488 5,823 5,273
Sales and marketing (a) & (c) 9,647 9,812 8,782
General and administrative (a) & (c) 2,322 1,908 1,933
Amortization of purchased intagible assets (b) 383 520 491
Restructuring and other charges (d) 304 799
Total operating expenses (a)-(d) 18,144 18,862 16,479
OPERATING INCOME (a) - (d) 10,065 7,674 9,164
Interest income 650 641 635
Interest expense (596) (628) (623)
Other income (loss), net 40 138 239
Interest and other income, net 94 151 251
INCOME BEFORE PROVISION 10,159 7,825 9,415
FOR INCOME TAXES (a) - (d)
Provision for income taxes (e) 2,118 1,335 1,648
NET INCOME (a) - (e) $ 8,041 $ 6,490 $ 7,767
Net income per share:
Basic (a) - (e) $ 1.50 $ 1.17 $ 1.36
Diluted (a) - (e) $ 1.49 $ 1.17 $ 1.33
Shares used in pre-share calculation:
Basic 5,370 5,529 5,732
Diluted 5,404 5,563 5,848
Cash dividends declared per common share $ 0.28 $ 0.12

Exhibit 2 Ten “I” statements in the Code of Business Conduct

Cisco “DNA” • I am ethical

• I know the Code

Values/Integrity • I share my concerns

• I respect others

Four Core Ethics Areas • I use resources responsibly

• I avoid conflicts of interest
• I understand policies related to gifts and entertainment
• I protect what is ours

Foundational • I follow the law

• I am accurate and ethical with our finances

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 Ethics@Cisco

Exhibit 3 Ethics decision tree

Not sure?
Check Cisco Policy Not sure?
Central for more Check the Ethics
information. Talk to your Office website Not sure?
Not sure? manager, your Human or contact Talk to your manager the
Contact the Resources representative, your manager Legal Department or
Legal Department or the Legal Department or Ethics Office the Ethics Office for
for guidance for guidance. for guidance. guidance.

? ? ? ?
Could this
Does this
Does this adversely
reflect Cisco
Is it legal? Yes comply with Yes Yes affect com- Yes
values and
Cisco policy? pany stake-
culture?
holders? The action may
have serious
consequences
No No No No do not do it

The action may The action may The action may

have serious have serious have serious Would I feel
consequences consequences consequences concerned if
do not do it do not do it do not do it ? this appeared
in a news
Yes
Not sure? headline? The action may
Talk to your have serious
manager the consequences
Legal Depatment, No do not do it
or the Ethics Office
for guidance.
Could this
adversely
? affect Cisco if
all employees
Yes
Not sure?
did it ? The action may
Talk to your
have serious
manager the
consequences
Legal Depatment,
No do not do it
or the Ethics Office
for guidance.
The decision
to move forward
appears appropriate.

Source: Cisco Code of Business Conduct

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Chapter 15 • Management Control-Related Ethical Issues

Exhibit 4 Special ethical obligations for employees with financial reporting responsibilities (revised Feb 2012)

All employees have an obligation to abide by the Cisco Code of Business Conduct (COBC), which includes adhering to
all internal financial and accounting policies. There are also special ethical obligations that apply to employees with
financial reporting responsibilities.
Our Chief Executive Officer (CEO), Chief Financial Officer (CFO) and Finance Department employees must adhere to
the following principles and also foster a culture throughout the company that helps to ensure the fair and timely report-
ing of Cisco’s financial results and condition. Because of their special role, the CEO, CFO and all members of the Cisco
Finance Department are bound by the following Financial Officer Code of Ethics, and each agrees that he or she will, in
his or her capacity as an employee of Cisco:

Integrity and Compliance

1. Act with honesty and integrity, avoiding actual or apparent conflicts of interest in personal and professional relation-
ships
2. Provide information that is accurate, complete, objective, relevant, timely, and understandable to help ensure full, fair,
accurate, timely, and understandable disclosure in reports and documents that Cisco files with, or submits to, gov-
ernmental agencies and in other public communications
3. Comply with the rules and regulations of federal, state, provincial, and local governments, and of other appropriate
private and public regulatory agencies
4. Act in good faith, responsibly, and with due care, competence, and diligence, without misrepresenting material facts
or allowing his or her independent judgment to be subordinated

Protecting Information and Assets

5. Respect the confidentiality of information acquired in the course of doing his or her work, except when authorized or
otherwise legally obligated to disclose information; confidential information acquired in the course of his or her work
will not be used for personal advantage
6. Achieve responsible use of and control over all assets and resources employed by or entrusted to Cisco

Personal Accountability and Serving as a Role Model

7. Share knowledge and maintain skills important and relevant to stakeholders’ needs
8. Proactively promote and be an example of ethical behavior as a responsible partner among peers, in the work envi-
ronment and the community
9. Promptly report to the Vice President of Governance, Risk, and Controls (GRC) and/or the Chairman of the Audit
Committee any conduct that he or she believes to be a violation of law or business ethics or of any provision of the
COBC, including transactions or relationships that reasonably could be expected to give rise to such a conflict. (Note:
It is against Cisco policy to retaliate against an employee for good-faith reporting of any potential or actual Code
violations.)

Violations
Violations of the Financial Officer Code of Ethics are serious. A violation, including a failure to report potential violations
by others, will be viewed as a severe disciplinary matter and may result in personnel action, including termination of
employment.

Stakeholder and Public Reporting

If anyone believes that a violation of the Financial Officer Code of Ethics has occurred, please contact Cisco Legal, the
Ethics Office, or the Audit Committee of the Board of Directors.
The Financial Officer Code of Ethics is complementary to the Cisco Code of Business Conduct and does not replace
responsibilities all employees have under the Cisco Code of Business Conduct and Cisco policies.

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 Ethics@Cisco

Exhibit 5 Examples provided in the COBC

What If…
What if my manager is exerting pressure to “make the numbers work?”
Your responsibility is to be honest and accurate. If you feel pressured to do otherwise, contact the Ethics Office, Legal or
Human Resources. You may also contact the Audit Committee of our Board of Directors. If you feel uncomfortable going
through internal channels, you can call the multilingual Cisco Ethics Line anytime, night or day, worldwide.
What if I am asked to book a deal without a purchase order?
All deals must be accompanied by a purchase order from a customer. These sales records ensure that our finances are
accurate and protect the company from fraud. Refer to the Global Bookings Policy for the required elements of a pur-
chase order.
What if I am asked to create a deal to sell a product or service to a reseller who I know is not authorized to receive it,
or for purposes other than for which a specific discount was given for competitive reasons?
This could result in product diversion to the “grey market” causing damage to Cisco’s legitimate resellers and possible
service abuse. If you believe that product/service is being sold outside the approved deal, contact Brand Protection and
the Ethics Office.
What if I am asked to structure a deal where the customer can choose only high discounted products?
Such a situation is called “cherry picking” and is not allowed. This can also result in discount leakage and potential prod-
uct diversion. Refer to your Finance controller or the Ethics Office if you believe you are being asked to structure a deal
in this way.

Source: Cisco Code of Business Conduct

Exhibit 6 Results of pulse survey

Q: I have confidence
Q: I can voice my Q: I know where to Cisco takes ethical Q: My mgt team sets a
# of Employee opinion without go to report ethics business concerns good example of values,
Year Respondents fear of retaliation concern or question seriously culture and COBC

2012 53,306 78% 87% 91% 84%

2011 55,158 75% 83% 90% 81%

2010 50,490 72% 83% 91% 81%

2009 47,245 65% 79% 92% 84%

This case was prepared by Research Assistant Michelle Spaulding and Professors Kenneth A. Merchant, Leslie Porter, and Lori
Smith.
Copyright © by Kenneth A. Merchant, Leslie Porter and Lori Smith.

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