Ethics and GAAP

🎯 Learning Objectives

Understand the fundamental importance of ethics in accounting
Explain the Fraud Triangle (Opportunity, Pressure, Rationalization)
Identify key GAAP principles: Measurement, Revenue Recognition, Expense Recognition, Full Disclosure
Compare GAAP (US) vs IFRS (International) approaches
Apply ethical reasoning to accounting scenarios

📚 Background & Principles

Ethics in accounting is not about personal beliefs—it's about maintaining the public trust in financial information. When accountants and businesses act unethically, the consequences ripple through:

🏛️ Loss of Investor Confidence

Unethical financial reporting causes stock price declines and capital flight

👔 Legal & Regulatory Consequences

Fines, lawsuits, loss of professional licenses, and even prison time

🏢 Reputation Damage

Once lost, trust is almost impossible to regain

💰 Economic Impact

Misallocation of resources harms entire economy

💡 Core Principle: Accounting ethics is about professional independence—making decisions based on facts and standards, not on pressure from management or personal gain.

🔺 The Fraud Triangle

Research shows that three factors are typically present when "good" people commit fraud. All three sides of this triangle must be present for fraud to occur:

Real-World Case: Luckin Coffee Financial Fraud (2020)

This coffee chain, once hailed as the "Starbucks of China," self-disclosed financial fraud in April 2020:

Pressure: The company needed to maintain a high-growth image to secure financing; founders had signed performance-based agreements with investors
Opportunity: During rapid expansion, internal controls were weak; the COO and team fabricated sales data
Rationalization: Management claimed "This is for the company's development, not for personal gain"

Result: Stock price plummeted 75%; eventually delisted from NASDAQ; paid $180 million to investors; SEC imposed a $100 million penalty.

💡 Key Lesson: Even "star startups" can collapse due to the Fraud Triangle. Robust internal controls and ethical corporate culture are essential for fraud prevention.

⚖️ Generally Accepted Accounting Principles (GAAP)

GAAP provides the "rules of the road" for financial accounting. Its primary goals are Relevance, Reliability, and Comparability.

The Four Fundamental Principles

1. Measurement Principle (Cost Principle)

Rule: Assets should be recorded at their historical cost—what the business actually paid for them.

Why it matters: Cost is objective and verifiable. Market value is subjective and changes daily.

⚠️ Common Error: Recording assets at their "fair market value" violates GAAP unless specific exception applies.

2. Revenue Recognition Principle

Rule: Revenue should be recognized when earned and realizable.

When is it earned? When service is performed or product is delivered

When is it realizable? When collection is reasonably assured

💡 Professional Insight: This principle prevents companies from "booking" revenue too early to inflate profits.

3. Expense Recognition (Matching Principle)

Rule: Expenses should be recorded in the same period as the revenues they helped generate.

Example: If December sales use electricity purchased in November, we record the expense in December (not November).

⚠️ Common Error: Recording expenses when paid (cash basis) rather than when incurred (accrual basis).

4. Full Disclosure Principle

Rule: Financial statements should include all information that would affect users' decisions.

Where disclosed? In notes to financial statements (not in main body of statements)

💡 Professional Insight: Notes are crucial for understanding contingencies, lawsuits, lease terms, and subsequent events.

🟡 Detailed Worked Examples

Example 1: Measurement Principle

Scenario: Java Joint purchased a delivery van in 2020 for $25,000. By 2024, the van is still in use but market value is $18,000.

Step 1: Apply Measurement Principle

Record van at $25,000 (historical cost)

Step 2: NOT Market Value

Do NOT record at $18,000 (market value) without justification

Why? Because: The $25,000 payment is a verified fact. The $18,000 market value is an estimate that changes regularly.

Example 2: Revenue Recognition

Scenario: A consulting firm signs a contract in December 2024 for $50,000 work to be performed in January 2025. Client pays $25,000 in December and $25,000 in January.

Step 1: Apply Revenue Recognition

Is revenue earned in December? NO—work hasn't been performed yet.

Step 2: Treat December Payment

The $25,000 received in December is Unearned Revenue (a liability)

Step 3: Recognize Revenue in January

When work is performed, convert $25,000 from Unearned Revenue to Revenue, recognize remaining $25,000 from January payment

Example 3: Expense Recognition (Matching)

Scenario: Company receives $2,000 utility bill in January 2025 for electricity used in December 2024.

Step 1: Identify Period

Electricity was used (benefited) in December 2024

Step 2: Apply Matching Principle

Record $2,000 utility expense in December 2024 (when it was used), NOT January 2025 (when bill was paid)

💡 Why This Matters: December's financial statements show the true cost of generating December revenue. Otherwise, December profit would be overstated.

🔴 Advanced Applications & Edge Cases

Industry-Specific GAAP

Different industries have specialized GAAP guidance (e.g., software revenue recognition, construction percentage-of-completion)

Materiality Concept

Small amounts that wouldn't affect user decisions may be ignored or aggregated. No bright-line test—requires judgment.

Conservatism Principle

When in doubt, choose the option that is less likely to overstate assets/income. Better to understate than overstate.

Going Concern Assumption

Assume business will continue operating indefinitely. Don't liquidate assets at "fire sale" prices unless evidence suggests otherwise.

🌍 GAAP vs IFRS

The US uses GAAP (FASB standards), while most of the world uses IFRS (IASB standards). Convergence efforts continue, but significant differences remain:

Aspect	GAAP (US)	IFRS (International)	Impact
Approach	Rule-based (specific rules for situations)	Principle-based (general principles require judgment)	GAAP more detailed; IFRS more flexible
Inventory Valuation	LIFO, FIFO, Weighted Average allowed	FIFO prohibited in most cases; similar to FIFO	Different costs in inflation vs deflation
Research & Development	Expensed immediately	Can be capitalized if criteria met	IFRS can show higher assets/income
Impairment Testing	Required when indicators present	Annual review required for all assets	More frequent testing under IFRS
Extraordinary Items	Shown separately below net income	Generally prohibited; merged with operations	GAAP highlights unusual events more

Interactive: Classification Challenge

For each scenario, determine whether GAAP or IFRS treatment would apply differently:

Scenario 1: During rising prices, company uses LIFO for inventory. Is this acceptable?

GAAP: Yes, LIFO allowed
IFRS: No, LIFO prohibited

Scenario 2: R&D costs for new software project. Can these be capitalized (recorded as asset)?

GAAP: Must expense immediately
IFRS: May capitalize if criteria met

🚫 Common Misconceptions & Professional Tips

❌ Misconception 1: "Ethics are just personal opinions—there's no right or wrong."

✅ Reality: While ethics involve judgment, professional accounting ethics are codified in standards (AICPA Code of Professional Conduct, SEC rules). Violations have objective consequences.

❌ Misconception 2: "Following GAAP is enough—ethics don't matter."

✅ Reality: GAAP is about how to measure and report. Ethics is about what to measure and report. You can follow GAAP technically while still being unethical (e.g., aggressive interpretation, hiding information).

❌ Misconception 3: "Only people who commit fraud are unethical."

✅ Reality: Passive participation in unethical behavior (looking the other way, not questioning suspicious entries) is also unethical. Silence can be complicity.

💡 Professional Tip #1: Always document your reasoning. If an entry seems unusual but management insists, write a memo explaining your concern and keep it in your files.

💡 Professional Tip #2: Establish clear "lines of communication." Know when to escalate to your supervisor, internal audit, or even external regulators if you encounter unethical pressure.

💡 Professional Tip #3: Stay updated on accounting standards. GAAP and IFRS evolve. A practice acceptable yesterday may be questionable tomorrow.

🧠 Memory Aids & Quick Reference

⚡ Quick Recall: The Four GAAP Principles

Measurement = Historical Cost (What you paid)

Revenue Recognition = Earned & Realizable (When delivered & collectable)

Expense Recognition = Matching (Same period as revenue helped generate)

Full Disclosure = All material information (Even if unfavorable)

⚡ Quick Recall: Fraud Triangle

Opportunity + Pressure + Rationalization = Fraud Risk

Remove any one side → No fraud (even if other two exist)

📖 Further Reading

AICPA Code of Professional Conduct

The ethical standard for US CPAs

Sarbanes-Oxley Act (SOX)

2002 law strengthening internal controls and auditor independence after corporate scandals

FASB (Financial Accounting Standards Board)

US body that establishes GAAP

IASB (International Accounting Standards Board)

Global body that establishes IFRS

📖 Glossary

Ethics

Moral principles that govern the conduct of individuals and organizations

GAAP

Generally Accepted Accounting Principles—the common set of accounting standards in the US

IFRS

International Financial Reporting Standards—global accounting standards used in 140+ countries

Fraud Triangle

Model explaining three conditions (opportunity, pressure, rationalization) that lead to fraud

Full Disclosure

GAAP principle requiring all material information to be included in financial statements

🎯 Final Knowledge Check

Test your understanding of Ethics and GAAP:

Question 1: A company signs contract in December for work in January. Client pays in December. When is revenue recognized?

December (when cash received)
January (when work performed)

Question 2: Which three factors form the Fraud Triangle?

Greed, Pressure, Opportunity
Opportunity, Pressure, Rationalization
Opportunity, Greed, Rationalization

Question 3: What principle requires recording assets at historical cost?

Revenue Recognition Principle
Measurement Principle (Cost Principle)
Full Disclosure Principle