Ethics in Finance

Ethics in Finance 

Financial and management accounting 

• Financial Accounting is defined as reporting of the financial position and performance of a firm through financial statements issued to external users on a periodic basis. 

• Management or Cost Accounting is the process of identifying, measuring, analyzing, interpreting, and communicating information for the pursuit of an organization's goals. 

 Financial Management 

• Financial management encompasses resource management and finance operations. 

• Resource management is the efficient and effective deployment of an organization's resources such as financial resources, inventory, human skills, production resources, or information technology when needed. 

• Financial operations is providing financial advice and guidance, support of the procurement process, providing pay support, and providing disbursing support 

 Ethical issues in Finance 

• Ethics in finance can be developed around three broad themes: 

        ▪ In financial markets 

        ▪ In financial services industry (including banking and insurance) 

        ▪ By financial people in organizations 

• Financial Transactions is the process by which the flow of money through an organization is handled 

• The Accounting Function keeps track of all financial transactions by documenting the money coming in and money going out 

• The Auditing Function is the certification of an organization’s financial statements or books as being accurate by an impartial third-party professional 

GAAP - Generally accepted accounting principles 

• The generally accepted accounting principles that govern the accounting profession – not a set of laws and established legal precedents, but rather a set of standard operating procedures within the profession 

• A set of accurate financial statements that present an organization as financial stable, operationally efficient, and positioned for strong future growth can do a great deal to enhance the reputation and goodwill of an organization 

Frauds in the financial sector 

Legal authorities define fraud as a crime that “involves the use of dishonest or deceitful conduct in order to obtain some unjust advantage over someone else”. 

Frauds include: 

• Financial services sector, i.e., credit card fraud, cheque fraud and other types 

• Insurance fraud 

• Telecommunication-related fraud 

• Securities-related fraud 

• Computer-related fraud 

• Unauthorized extension of credit facilities; 

• Pledging of spurious goods; 

• Hypothecating goods to more than one bank; 

• Inflating the value of goods; 

• Removing goods with the connivance or negligence of bank employees; 

• Pledging of goods belonging to a third party; 

• Accepting obsolete and inadequate stocks; 

• Frauds in deposit accounts are opening of bogus accounts, forging signatures of introducers, and collecting through such stolen accounts or forged cheques or bank drafts. 

• Frauds are also committed in the area of granting overdraft facility in the current accounts of customers • Credit card fraud 

• Phishing 

Frauds in insurance sector 

We can identify three types of fraud in the insurance industry: 

1. Internal fraud against the insurer perpetrated by an employee; 

2. Policy holder/claims fraud committed against the insurer, in the purchase and/or execution of an insurance product by obtaining wrongful coverage or payment; and 

3. Intermediary fraud committed against the insurer or policy holders by intermediaries – independent broker/agent. 

Frauds in insurance process 

• The possibility of fraud is prevalent during any one of the three stages in the insurance process: 

a. Policy Proposal stage; 

b. Policy Contract stage; and 

c. Claim Process stage. 

• Frauds are also seen in the non-life insurance sector 

Combating insurance fraud 

1. Collection of proper evidence 

2. Need for regulation 

3. Regulation of allied services 

4. Need for judicial co-operation 

5. Insurers should aim at conviction

6. Need for transparency and fair play 

7. Insurers’ coalition 

8. Building consumers’ awareness 

9. Rewards for whistle-blowers 

10. Effective legislation and judicial action 

 Measures against bank frauds 

• Prevention of Money Laundering Act, 2002 

          ▪ Reporting of Cash and Suspicious Transactions 

       ▪ Types of Reports: Cash Transaction Reports (CTR), Suspicious Transaction Report (STR), Counterfeit Currency Report (CCR) 

          ▪ Reporting to RBI 

          ▪ Other guidelines are also given under the Act to curb the menace of money laundering 

          ▪ Compliance to Anti-Money Laundering Standards 

• The Banking Ombudsman Scheme, 2006 

Characteristics of Management Prone to Fraud 

• Unduly aggressive financial Targets 

• Domination by person or group without controls 

• Aggressive accounting practice to keep stock prices high 

• Pressure to reduce tax liabilities 

• Major performance related compensation 

• Non-Financial personnel involved in accounting matters 

Ethical issues in Finance 

• Financial statements 

• Hostile Takeovers 

• Financial Markets 

–Insider Trading 

Fraud in Financial Statements 

• Fictitious Revenues 

• Concealed Liabilities and Expenses 

• Fraudulent Asset Valuations 

• Improper or Fraudulent Disclosures or Omissions 

        ➢Creative accounting – form of fraudulent financial reporting so as to provide misleading information. 

Duties of an Auditor 

• To give an accurate statement to the members about the state of affairs of a company 

• To meet the objectives of the Companies Act 1985 and also the Articles of Association 

• To be reasonably skillful and careful in identifying the true nature of the accounts 

Ethical Audit 

• An audit that assess a business’s structures, procedures, systems and policies. 

• It measures the extent to which the activities of a business comply with the standards it has publicly declared to its external customers 

• It measures business conduct against varied moral standards of the community. 

Objectives of Ethical Audit 

• To provide a critical assessment of functioning of business 

• To investigate into acquisition or restructuring operations 

• To determine the type of training necessary for employees 

• To establish ethical conduct of business 

• To enhance, measure and promote the quality that increases business performance by assessing them against the ethical business objective 

• To improve the quality of governance by evaluating the performance and ensuring that financial information is both available and reliable 

Ethical Issues in Financial Markets 

• Deception: act of misrepresenting relevant information 

• Churning: Excessive or inappropriate trading for clients account by a broker who has control over the account with intent to generate commissions rather than to benefit client 

• Unsuitability 

• Unfairness in Markets 

Insider Trading 

• Refers to trading on price sensitive information by company employees or individuals closely connected with the firm 

• This information has not been disclosed to other market participants 

Ethics & Insider Trading 

• It violates equality of opportunity 

• Does not give a level playing field between insiders and outsiders 

• Might harm exchange as a whole because investors might not be willing to trade on exchange that does not give shareholders their rights. 

Anti-takeover defense measures 

• Poison Pills 

• Green mail 

• Golden Parachute 

• People 

Pill Poison Pills 

• An anti-takeover device used by company’s management to make takeover prohibitively expensive for the bidders 

• Company under target changes AOA so that group of Shareholders have special rights to buy and sell preferred stock at highly favorable prices (At times below market price) 

 Ethics & Poison Pills 

• Poison pills are prohibited in Britain by takeover code because they prevent open competition between bidders for shares 

• Use of poison pills are ethical if they are designed to protect the management from unwanted takeover bids. Greenmail 

• It occurs where a potential takeover agent purchases stock in a company 

• After the purchases have totaled five percent the agent must announce his intention to takeover the company, if that is the intent

 • Stock prices go up in anticipation of takeover battle 

• Management of target company sends greenmails to prevent a shareholder from taking over the company 

• Takeover agent ends up selling the shares back to company at an increased or higher negotiated price 

 Ethics & Greenmail 

• Target company may be forced to incur debts to raise funds to finance the buy back of shares at premium price 

Golden Parachute

 • A company gives lucrative benefits to its top executives such as stock options, bonuses, etc 

• Presence of parachute allows management to evaluate takeover bid more objectively 

People Pill

 • Management threatens that in event of a takeover the entire management team will resign • If managers act in their own interest rather than company’s long term value then they are acting unethically

 Management Buyout 

• It occurs when management decide to bid for the company 

• They convert the company into a private company and at a later date, bring it back to market to make substantial profits. 

Ethics & Management Buyout

 • Shareholder believe that management may resort to unethical practices to bring down share prices and buy out at cheaper rate 

• Unethical activities can involve leaking confidential information by managers for their benefit during buy out