Ethical Issues Related to Financial Reports (HSC SSCE Business Studies): Revision Notes
Ethical Issues Related to Financial Reports
Introduction to ethical financial reporting
Financial managers and accountants have both ethical and legal obligations to ensure financial records are accurate and honest. They must maintain the highest professional standards when preparing financial reports and making financial decisions.
Creative accounting refers to manipulating financial information to present a more favourable but inaccurate picture of a business's financial position. This practice must always be avoided, as it misleads stakeholders and violates ethical standards. In recent years, increased scrutiny has been placed on unethical financial practices, with high-profile cases resulting in investigations and regulatory action.
Creative accounting may seem to offer short-term advantages, but it fundamentally undermines trust in financial reporting. When stakeholders discover financial manipulation, the long-term damage to reputation and relationships far exceeds any temporary benefits.
Financial management decisions must reflect both the business's objectives and the interests of owners and shareholders. Ethical considerations affect multiple aspects of financial management, from day-to-day record keeping to strategic decisions about funding and financial reporting.
Key ethical considerations in financial management
Asset valuation
The valuation of assets, including inventories and accounts receivable, requires careful ethical consideration. These valuations directly influence working capital levels and therefore affect the short-term financial stability of a business.
If inventories and accounts receivable are overvalued (for example, when a business fails to make provisions for bad or doubtful debts), working capital will appear artificially high. This creates a misleading picture of the business's true financial position. Stakeholders relying on this information may make poor decisions based on inaccurate data.
Working capital is calculated as current assets minus current liabilities. Since inventories and accounts receivable are major components of current assets, any overvaluation directly inflates the working capital figure, giving a false impression of the business's liquidity and short-term financial health.
Financial managers must ensure asset valuations are realistic and properly account for potential losses or depreciation. This protects the interests of shareholders, creditors, and other stakeholders who depend on accurate financial information.
Worked Example: Impact of Overvalued Assets
Consider a business with the following position:
- Current assets (including inventory): $500,000
- Current liabilities: $300,000
- Working capital: $200,000
If the business fails to account for $50,000 of obsolete inventory that should be written down:
- Overstated current assets: $500,000 (should be $450,000)
- Overstated working capital: $200,000 (should be $150,000)
- This represents a 25% overstatement of the true working capital position
Stakeholders making decisions based on the $200,000 figure may overestimate the business's ability to meet short-term obligations.
Debt funding and shareholder risk
When businesses use debt funds extensively to finance their activities, this creates an ethical consideration regarding shareholder risk. While debt funding can be used strategically to increase profits (through financial leverage), it also increases the financial risk for shareholders.
Shareholders bear the ultimate risk if the business cannot meet its debt obligations. Financial managers have an ethical responsibility to consider this impact when making decisions about the capital structure of the business. They must balance the potential benefits of debt funding against the increased risk to shareholders, ensuring shareholders are fully informed about the level of financial risk they are exposed to.
Ethical Responsibility to Shareholders
Financial managers must ensure shareholders understand that:
- Higher debt levels can amplify returns during profitable periods
- However, they also magnify losses during downturns
- Shareholders may lose their entire investment if the business becomes insolvent
- Full transparency about debt levels and associated risks is essential for informed decision-making
Budget preparation
Budgeting involves estimating future expenditures and revenues. A common business practice is to overestimate expenditures and understate revenues to create a buffer for unexpected events. While this conservative approach may seem prudent, it raises ethical questions.
This practice can distort the true expected performance of the business, affecting decisions made by managers and stakeholders. If budgets are consistently set with excessive caution, it may lead to underinvestment in growth opportunities or misallocation of resources. Financial managers must strike a balance between prudent planning and honest representation of expected financial outcomes.
While some level of conservative budgeting is acceptable as a risk management strategy, deliberately manipulating budget figures to an unrealistic degree crosses the line into unethical territory. The key is transparency—stakeholders should understand the assumptions underlying budget figures and the degree of conservatism applied.
Legal framework and corporate governance
Relationship between ethics and legislation
Ethical considerations are closely linked to the legal aspects of financial management. Legislation exists to guard against unethical business activity, but there is often a time lag between the recognition of an ethical problem and its implementation through law. This means businesses must maintain ethical standards even in areas not yet fully covered by legislation.
Laws relating to corporations are designed to protect stakeholders and ensure transparency. However, ethical business practice goes beyond mere legal compliance—it requires active commitment to honesty and integrity in all financial dealings.
Ethics vs. Law: The Gap
The relationship between ethics and law creates an important distinction:
- Legal compliance is the minimum standard—what you must do
- Ethical practice is the higher standard—what you should do
- Just because something is legal doesn't necessarily make it ethical
- Leading businesses adopt ethical standards that exceed legal requirements
Directors' legal duties
Under the Corporations Act 2001 (Cth), company directors have specific legal duties related to financial management. These duties include:
Directors' Legal Duties Under Corporations Act 2001
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Act in good faith: Directors must act honestly and in the best interests of the company, not for personal gain or ulterior motives.
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Exercise power for proper purpose: Directors must use their powers in ways that are appropriate and consistent with the company's objectives, acting in the company's name rather than for personal benefit.
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Exercise discretion reasonably and properly: Directors must make informed, rational decisions based on relevant information and careful consideration.
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Avoid conflicts of interest: Directors must not place themselves in positions where their personal interests conflict with their duties to the company.
These duties create a framework for ethical financial decision-making at the highest level of corporate governance.
ASX corporate governance requirements
The Australian Securities Exchange (ASX) Corporate Governance Council sets requirements for corporations listed on the ASX. These requirements focus on:
- Compliance with relevant laws and regulations
- Disclosure of material information to shareholders
- Transparency of company operations and financial position to the public
Listed companies must adhere to these governance standards, ensuring that financial information is reported accurately, completely, and in a timely manner. This protects investors and maintains confidence in the financial markets.
The ASX Corporate Governance Principles operate on a "comply or explain" basis. While companies are expected to follow the principles, they may depart from recommendations if they can explain why alternative governance arrangements are more appropriate for their circumstances. However, any departures must be clearly disclosed to shareholders.
Audited accounts
Purpose and importance of audits
An audit is an independent check of the accuracy of financial records and accounting procedures. Audits play a crucial role in ensuring financial reports provide accurate information for users and maintain stakeholder confidence.
The primary purpose of an audit is to obtain an independent opinion on the financial statements of a business. Auditors establish whether the financial statements are fairly presented and comply with generally accepted accounting principles. This independent verification is essential for maintaining trust in financial reporting.
Potential Users of Audited Information
Financial reports verified through audits are relied upon by diverse stakeholders:
- Financial institutions considering lending to the business
- Owners and shareholders monitoring their investment
- Potential investors evaluating the business
- Regulatory authorities ensuring compliance
These stakeholders rely on the independent verification provided by auditors before making important decisions about the business.
Types of audits
There are three main types of audits, each serving different purposes:
1. Internal audits
Internal audits are conducted by employees within the organisation. Their purpose is to:
- Check accounting procedures are being followed correctly
- Verify the accuracy of financial records
- Identify potential weaknesses in internal controls
- Provide ongoing monitoring of financial processes
Internal audits help businesses maintain continuous oversight of their financial operations and identify issues before they become serious problems.
Internal audits provide the first line of defence against financial irregularities. Because they are conducted by staff familiar with the business's operations, internal auditors can identify procedural weaknesses and recommend improvements quickly. However, their internal position means they lack the complete independence of external auditors.
2. Management audits
Management audits review the firm's strategic plan to determine if changes should be made. These audits examine multiple factors affecting strategic planning, including:
- Human resources effectiveness
- Production processes efficiency
- Financial management practices
- Overall strategic direction
Management audits are broader in scope than financial audits and help ensure the business is operating efficiently across all functions.
3. External audits
External audits are conducted by independent, specialised accountants from outside the organisation. Under the Corporations Act 2001 (Cth), companies classified as "large" must have their annual financial report audited externally.
The Australian Securities and Investments Commission (ASIC) defines a "large" company as one that meets two of the following three criteria at the end of the financial year:
- Consolidated revenue of $50 million or more
- Consolidated gross assets of $25 million or more
- 100 or more employees
For small businesses, external auditors are typically only used if the business is being sold or to check against theft and fraud. The cost of external audits can be significant, so smaller businesses generally rely on internal controls and occasional independent reviews rather than full external audits.
When an external audit is complete, the auditor issues a statement indicating that:
- The company's records are accurate to the best of the auditor's knowledge
- The records give a true and fair view of the state of affairs
- The records comply with generally accepted accounting standards and practices
International financial reporting standards (IFRS)
Since 2005, businesses have been required to adopt International Financial Reporting Standards (IFRS). These standards aim to achieve:
- Greater transparency in financial reporting
- Increased accountability for businesses of all sizes
- Standardisation of accounting practices globally
- Easier comparison of financial information across countries
Benefits of Global Standardisation
IFRS particularly assists transnational corporations operating in multiple countries, as it allows consistent reporting across different jurisdictions. Before IFRS adoption, multinational companies often had to prepare multiple versions of financial statements to comply with different national accounting standards—a costly and time-consuming process.
Role of audits in preventing financial misconduct
Both internal and external audits assist in guarding against:
What Audits Prevent
- Unnecessary waste of resources
- Inefficient use of business assets
- Misuse of funds for unauthorised purposes
- Fraud and deliberate deception
- Theft of company assets
Auditors check control procedures by physically verifying assets. For example:
- Cash on hand is counted and compared to records
- The condition and quantity of inventory is physically checked
- Accounts receivable are verified through confirmation with customers
- Non-current assets are inspected and matched to records
This physical verification process ensures that records accurately reflect the actual state of the business's assets.
Example: Physical Verification Process
During an audit, auditors might conduct the following checks:
Inventory verification:
- Select a random sample of inventory items from records
- Physically locate and count these items in the warehouse
- Check condition (obsolete, damaged, or saleable)
- Compare physical count to recorded quantities
- Investigate any discrepancies
Cash verification:
- Count physical cash in registers and safes
- Compare to cash book balances
- Review bank reconciliation statements
- Verify bank balances with direct confirmation from banks
These procedures provide assurance that recorded assets actually exist and are valued appropriately.
Case study: AUSTRAC compliance audits
Case Study: AUSTRAC Compliance Audits
In June 2019, Australia's financial crime watchdog AUSTRAC demanded an external audit of Afterpay regarding its compliance with anti-money laundering and counter-terrorism financing laws. The independent auditor's report, completed by November 2019, concluded that:
- Afterpay's business model was inherently low risk for exploitation by money launderers and terrorist financiers
- The company had a strong compliance culture
- Appropriate controls were in place
Similarly, in September 2019, AUSTRAC ordered an external audit of PayPal Australia to examine compliance with laws requiring businesses to report funds or property transferred to or from Australia. These cases demonstrate how external audits are used by regulators to ensure financial services companies maintain appropriate controls and comply with legal requirements.
Record keeping
Importance of accurate record keeping
All accounting processes depend on how accurately and honestly data are recorded in financial reports. Source documents must be created for every transaction, including those involving cash payments. This ensures a complete audit trail and allows verification of all business activities.
Maintaining accurate records serves multiple purposes:
- Provides evidence of business transactions
- Supports tax compliance
- Enables effective financial management
- Protects against fraud and errors
- Demonstrates ethical business practices
Source documents form the foundation of the entire accounting system. Every financial transaction should be supported by appropriate documentation—invoices, receipts, bank statements, contracts, or other records. Without proper source documents, there is no reliable basis for preparing financial statements or verifying their accuracy.
Consequences of poor record keeping
There is often temptation for businesses to receive payment in cash (notes and coins) without recording the transaction. If cash received is not recorded, it will not appear as business revenue, artificially reducing the business's reported profit for the year. This may result in a lower tax burden, making it an attractive but highly unethical and illegal practice.
Consequences of Cash Transaction Manipulation
The Australian Taxation Office (ATO) regularly monitors business operators. Those found evading taxation responsibilities face serious consequences:
- Fines far exceeding any perceived tax savings
- Criminal prosecution for tax evasion
- Damage to business reputation
- Loss of customer trust and loyalty
Customers increasingly prefer dealing with honest and ethical businesses. Being caught engaging in tax evasion can alienate customers and harm long-term business viability.
Legal requirements for record retention
Proper financial records must be kept for a minimum of five years. This legal requirement ensures businesses maintain adequate documentation to support their financial reports and tax obligations. Records must be:
- Complete and accurate
- Securely stored and accessible
- Maintained in an appropriate format
- Available for inspection by authorities
The five-year retention period is not merely a suggestion—it is a legal requirement. Businesses that fail to maintain adequate records may face penalties, and the absence of proper documentation can severely hamper their ability to defend their tax positions if questioned by the ATO.
Proposed cash payment restrictions
Proposed Legislation: Cash Payment Limits
A bill currently before Parliament proposes making it a criminal offence for businesses to make or accept cash payments of $10,000 or more. The proposed penalties include:
- Up to two years of imprisonment
- Fines of up to $25,200 for individuals
This measure aims to:
- Reduce black economy behaviour
- Prevent money laundering
- Ensure large transactions cannot avoid regulatory scrutiny
- Maintain transparency in financial dealings
Reporting practices
Stakeholder entitlements to financial information
Accurate financial reports are necessary not only for taxation purposes but also for other stakeholders who are entitled to access a business's financial information.
Shareholders in private companies are legally entitled to receive financial reports annually, even if:
- The company is a small business
- The shareholders are family members
- The company is not publicly listed
This requirement ensures transparency and protects shareholder interests, regardless of company size or ownership structure.
The requirement for private companies to provide financial reports to shareholders exists even in closely held family businesses. This protects minority shareholders and ensures all owners have access to information about their investment, preventing situations where controlling shareholders could withhold financial information.
Consequences of inaccurate reporting
Attempting to portray profit as lower than it actually is constitutes fraud against the ATO. This practice is both illegal and unethical, and can have negative consequences beyond legal penalties:
How Inaccurate Reporting Harms Business Objectives
Impact on capital raising: Understating profit may make it more difficult to:
- Persuade existing shareholders to invest additional capital
- Convince banks to provide loans
- Attract new investors
- Negotiate favourable financing terms
Impact on business sales: If the business is sold as a going concern:
- Purchasers will scrutinise financial reports from multiple years
- Understated profits reduce the perceived value of the business
- Overvalued assets will be identified during due diligence
- Potential buyers may withdraw or reduce their offers
Inaccurate financial reporting can therefore prove counter-productive, harming the business's ability to achieve its strategic and financial objectives.
Case study: icare financial mismanagement
Case Study: icare Financial Mismanagement
In 2020, an investigation was launched into the NSW workers compensation scheme, icare, after the company lost hundreds of millions of dollars annually due to financial mismanagement.
As early as 2018, the State Insurance Regulatory Authority (SIRA) had concerns about the company's financial viability and solvency. By 2020:
- The regulator warned that the fund's liabilities exceeded assets by $459 million
- The company's solvency was at serious risk
- SIRA referred the conduct to the Independent Commission Against Corruption (ICAC)
- Multiple resignations followed the investigation
Key Lesson: This case illustrates the serious consequences of poor financial management and the importance of accurate, ethical financial reporting to protect stakeholder interests. When financial problems are hidden or understated, they inevitably grow larger and more difficult to resolve.
Case study: corporate tax transparency
Case Study: ATO Corporate Tax Transparency Report 2017–18
The ATO's corporate tax transparency report for 2017–18 revealed significant issues with corporate tax compliance. Key findings included:
Overall tax statistics:
- Of 2,214 entities covered by the data, 710 (32%) did not pay any tax
- 1,504 corporate entities reported tax payable totalling $52.3 billion
- This represented a net increase of $6.6 billion from the previous year
- The increase was primarily driven by the mining, energy and water sectors
Concentration of tax liability:
- Corporate entities with income over $5 billion represent only 2% of the population
- However, they are liable for 53% ($27.9 billion) of total tax payable
- This demonstrates the significant contribution of large corporations
Reasons for nil tax payable:
The 710 companies that paid no tax in 2017–18 fell into several categories:
- 269 entities: Reported taxable income but used prior-year losses to offset current profit
- 242 entities: Reported an accounting loss for the year
- 146 entities: Reported accounting profit but reconciliation items resulted in a tax loss
- 53 entities: Reported taxable income but were entitled to offsets (such as research and development tax incentives) equal to or exceeding tax owed
ATO enforcement actions:
The ATO deputy commissioner noted that groups consistently reporting losses or unusually low taxable incomes attract increased attention. The ATO's Tax Avoidance Taskforce conducts specialist audits where tax avoidance is suspected.
Impact of anti-avoidance legislation:
Laws passed by the Federal Government have strengthened the ATO's ability to take action against tax avoidance:
- The Multinational Anti-Avoidance Law (MAAL) has prompted companies like Facebook and Google to restructure operations
- More than $7 billion of sales income is now being booked in Australia as a result
- The Diverted Profits Tax (DPT) helps the ATO obtain necessary information when companies deliberately obscure their activities
- Transfer pricing laws provide tools to challenge inappropriate profit shifting
Key Lesson: This case study demonstrates the ongoing challenge of ensuring ethical corporate tax compliance and the importance of robust regulatory frameworks. Transparency and enforcement mechanisms are essential to maintain public confidence in the tax system.
Exam guidance
When answering questions on ethical issues in financial reports, consider:
For "describe" questions:
Clearly explain what the ethical issue is and why it matters. Use specific examples like asset overvaluation or budget manipulation. Structure your answer to:
- Define the ethical issue
- Explain its significance
- Provide a concrete example
For "explain" questions:
Show the cause-and-effect relationship. For example, explain how overvaluing inventory leads to inflated working capital, which misleads stakeholders about financial stability. Your answer should demonstrate:
- The initial action or decision
- The direct consequences
- The broader impact on stakeholders
For "analyse" questions:
Break down the issue into components. Examine:
- Who is affected (stakeholders)
- What the potential consequences are
- How the issue relates to both ethical and legal obligations
- Why it matters for business sustainability
Consider multiple perspectives and the interconnections between different aspects of the issue.
For "evaluate" or "assess" questions:
Make a judgement about the effectiveness of measures addressing ethical issues. Consider:
- Strengths and limitations of current regulations
- Effectiveness of auditing processes
- Balance between legal compliance and ethical practice
- Short-term versus long-term impacts
Support your judgement with evidence and consider alternative viewpoints before reaching a conclusion.
Always support your answers with relevant case studies or real-world examples, such as the icare investigation or ATO tax transparency data.
Remember!
Key Points to Remember:
- Financial managers have both ethical and legal obligations to ensure accurate, honest financial reporting
- Creative accounting that presents misleading financial information must always be avoided
- Key ethical issues include asset valuation, use of debt funds, budget preparation, and record keeping
- Directors have specific legal duties: act in good faith, exercise power properly, use discretion reasonably, and avoid conflicts of interest
- An audit is an independent verification of financial records—three types are internal, management, and external audits
- Large companies must have external audits under the Corporations Act 2001 (meeting 2 of 3 criteria: $50m revenue, $25m assets, or 100 employees)
- Financial records must be kept for a minimum of five years
- Inaccurate reporting can harm a business's ability to raise capital or sell successfully
- The ATO, ASIC, and AUSTRAC actively monitor and enforce compliance with financial reporting requirements
Key Terms:
- Audit: Independent check of the accuracy of financial records and accounting procedures
- Creative accounting: Manipulating financial information to present an inaccurate picture
- International Financial Reporting Standards (IFRS): Global accounting standards for transparency and consistency
- Working capital: Current assets minus current liabilities
- Stakeholders: Parties with an interest in the business (shareholders, creditors, employees, regulators)
Critical Frameworks:
- Directors' duties under Corporations Act 2001: Good faith, proper purpose, reasonable discretion, avoid conflicts
- Types of audits: Internal, management, external
- Large company criteria: Revenue ≥ $50m OR Assets ≥ $25m OR Employees ≥ 100 (must meet 2 of 3)