CHAPTER 7

ETHICAL ISSUES IN FINANCIAL

ENTITIES
Chapter objectives
• Discuss why a large set of financial entities needs to be considered
when reflecting on ethical issues in accounting and finance.
• Determine what some of the critical ethical concerns are in the
banking sector.
• Identify ethical issues relevant to stockbrokers and traders.
• Describe the ethical issues of private equity firms and hedge funds.
• Express what the potential ethical pitfalls are for auditing and
consulting firms.
• Provide examples of professional bodies and government entities
that provide ethical oversight in the financial sector.
Introduction
It is ironic that, in 1999, in the introduction on a CD-ROM on
ethical practice circulated to all employees of Arthur Andersen, an
international consulting and auditing firm, the managing partner
noted that ‘the day we lose the public trust is the day we go out of
business’.

In 2002, with 85 000 employees worldwide, the leading

accounting firm Arthur Andersen went out of business for just that
– losing the trust of their customers and key stakeholders (Cooper
2013).
Financial entities
It is appropriate to look at ethical issues related to financial entities,
given the importance of the financial sector to the effective
functioning of business and, more importantly, to the global
economy and the myriad of players coalescing in this sector.
Auditing and consulting firms
Global financial crisis
Watch the YouTube clip for a visual depiction of the GFC.

Understanding the Financial Crisis – Very Good Explanation! 2009,

YouTube, Mostafa Mourad, 17 March, <https://
www.youtube.com/watch?v=qqUGoVez8xg>.
Banks
In an effort to keep banking systems safe, stricter liquidity rules,
governing how foreign banks can manage cash on hand, are being
applied globally.

Previously, subsidiaries of well-capitalised foreign banks were able to

operate offshore without having to meet minimum capital
requirements. However, they are now required to ring-fence their
foreign operations, and be separately capitalised.
Banks
Banks have been implicated in a number of unethical activities, such
as:
• improper procedures
• excessive executive compensation
• collusion
• money laundering
• price manipulation
• violation of sanctions
• usurious practices.
Banks
Excessive bankers’ compensation
For a discussion on the BBC concerning RBS Chief, Stephen Hester's
bonus, see:

RBS Chief’s Bonus: Right or Wrong? 2012, YouTube, FreedomAlley, 27

January, https://www.youtube.com/watch?v=pInOlGKedkc.

Collusion – the LIBOR scandal – what is it? To find out, see:

Unknown LIBOR Fraud of the Century (Barclays) 2012, YouTube,

SergiyBeloy, 22 August, <
https://www.youtube.com/watch?v=wak5M_DxkSQhttps://www.yout
ube.com/watch?v=G0heLiBe2MEhttps://www.youtube.com/watch?v=
Fz1rwyX4DIY
>.
Banks
Money laundering
For an insightful short clip on how money laundering works, see:

How money laundering works 2011, YouTube, Ronnie Darko, 10 May,

<https://www.youtube.com/watch?v=pGocvqSKi4k>.
Banks
Banking scandals
For a discussion on HSBC reportedly
helping drug cartels and terrorist
regimes launder billions of dollars,
see:

The New Wave of Bank Scandals:

Money Laundering, Drug Cartels and
Libor Scandals 2013, YouTube, PJ
Media, 5 September, <https://
www.youtube.com/watch?v=KkM17
Gq4S9s
>.
Stockbrokers/traders
There have been a number of high-profile cases of enormous losses
incurred by traders involved in speculative trading with someone else’s
money. Such cases have resulted in severely weakened, or in some
cases even prompted the demise of, the organisations they were
working for.

The press usually refers to them as rogue traders.

Churning is the encouragement of investors to make numerous and

frequent trades for the sole purpose of generating additional income
for a broker.
Stockbrokers/traders
Manipulative trading: where the trader, or their organisation,
deliberately manipulates the market for financial gain.
• Stuffers – overwhelm exchanges of data to slow down competitors.
• Danglers – sending out data that can force a squeezed trader to
chase a price against their interests.
• Pack hunters – groups of traders who become aware of each
other’s presence, even though they do not know one another. They
work in tandem to maximise the chance of triggering a cascading
effect.
Investment advisers/financial planners
Consumer advocacy groups have cautioned that the financial
planning industry is ’structurally corrupt’, and that the financial
advisory industry is driven by a conflict of interest which sees
financial products promoted based on commissions, rather than on
the specific benefit to the client (Chaplin 2012).
Investment advisers/financial planners
Ethical issues in relation to investment advisers/financial planners:
• an emphasis on product selling rather than tailored advice
• recommendations to switch to a super fund provider paying the
adviser a higher commission with no obvious benefit to the client
• encouraging borrowing in order to invest mainly for the benefit of an
adviser who is paid on the percentage of assets invested.
Private equity firms
A private equity firm’s main role is
to make money by taking over
poorly managed companies,
improve their performance and
then sell them.

Private equity firms usually charge

a 2% annual fee to manage
investors’ capital, and take 20% of
the profits. Private equity firms now
get approximately two-thirds of
their revenue from fixed fees,
regardless of performance.
Equity firms
Ethical grey areas

• One notable ethical grey area is that equity firms can burden a
company with debt then take cash out as dividends, thus weakening
the organisation, with the likely outcome of bankruptcy.

• Tax deductions can be generated on interest payments on debt, as

well as taken out as cash. The profits generated from these
transactions are called carried interest and are commonly taxed as
capital gains and at a lower rate than income (‘Private equity’ 2012).
Hedge funds
Hedge funds are investment funds
utilising sophisticated and risky
investment techniques, which are
available to institutions and
individuals of meaningful wealth
(BarclayHedge 2013).
Hedge funds
Ethical issues
Portfolio pumping – where hedge fund managers manipulate the
prices of stocks they hold in order to have better returns to report to
investors. How this actually occurs is that there is an increase in
trading activity among some hedge funds on the last day of the month,
and quarter, which artificially inflates returns with as little as
US$500 000 in trades.

Conflict of interest – for example, it was alleged that Goldman Sachs

misled Abacus investors by failing to disclose that Paulson and
Company, a hedge fund, had been involved in selection of the
securities and had bet against them.
Auditing and consulting firms
Auditors are primarily responsible for highlighting fraudulent financial
reporting; that is, the intentional misrepresentation or omission of
disclosures or dollar amounts with the objective to deceive financial
statement readers.

This includes manipulation, falsification or alteration of accounting

records, and misrepresentation.

Auditors are also alert to misappropriation of assets – theft of

company cash (embezzlement), inventory, or other assets causing
distortions in the financials.
Auditing and consulting firms
Ethical issues
The requirement of greater scrutiny of auditing firms has come about
through ethical issues such as:

• avoidance of duty of care

• accounting improprieties
• collusion
• erosion of independence
• conflict of interest.
Auditing and consulting firms
Double duty arrangements
In one year, Arthur Andersen was paid US$52 million from Enron, of
which US$25 million was in audit fees, and US$27 million was from
other services including tax and consultancy work.

They indicated, however, that their independence was not impaired by

what are commonly called double duty arrangements.
Auditing and consulting firms
Threats to independence
• Self-interest threats – the threat that a financial, or other interest, will
inappropriately influence professional judgement.
• Self-review threats – the threat that a professional will not
appropriately evaluate the results of a previous judgement made.
• Advocacy threats – the threat that a professional will promote a client’s
or employer’s position to the point that objectivity is compromised.
• Familiarity threats – the threat that due to a long or close relationship
with a client or employer, a professional will be too sympathetic to their
interest or too accepting of their word.
• Intimidation threats – the threat that a professional will be deterred
from acting objectively because of actual or perceived pressures,
including attempts to exercise undue influence.
Ethics in the media: Bank irregularities
In 2014, Korean financial authorities and prosecutors are investigating
allegations that employees Kookmin Bank, South Korea's largest
lender, faked government bonds and embezzled the money (‘Massive
irregularities at South Korea’s largest bank’ 2014).
Professional ethical oversight
International accounting bodies
• The International Federation of Accountants (IFAC), which is
cumulatively supported by the operation of four independent
standards setting boards:
• The International Auditing and Assurance Standards Board (IAASB)
• The International Accounting Education Standards Board (IAESB)
• The International Ethics Standards Board for Accountants (IESBA)
• The International Public Sector Accounting Standards Board
(IPSASB).
Professional ethical oversight
National regulators in Australia
• The Australian Securities and Investment Commission (ASIC), which
oversees auditors and liquidators, financial planners and company
directors
• The Tax Practitioners Board (TPB), which oversees tax practitioners
• The Australian Prudential Regulation Authority (APRA), which
oversees auditors and trustees of superannuation funds, directors
and senior managers of insurance companies
• The Insolvency Trustee Service Australia (ITSA), which oversees
trustees in bankruptcy
Ethics at the movies
*Margin Call

Starring Kevin Spacey, Demi Moore and Jeremy Irons.

This movie follows the drama at a Wall Street investment bank during
the early stages of the Global Financial Crisis.

• Margin Call 2011, motion picture, Barnum, RO, Benaroya, M,

Dodson, N, Jenckes, J, Moosa, C & Quinto, Z, <
http://www.youtube.com/watch?v=uj4QrAcwVi0>.

* Author’s pick
Image credits
• Shutterstock.com / JuliusKielaitis; Cartoonresource; Cartoonresource;
Cartoonresource