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5. Mark-to-Market (M2M) Accounting and the Demise of AIG (Chapter 8, pages
647–649)
What this case has to offer
This case allows students to discuss the causal connections between financial reporting and economic
Teaching suggestions
This is a good opportunity to review the accounting rules associated with financial instruments and
Discuss of ethical issues
1. Does accounting cause bankruptcy?
The purpose of generally accepted accounting principles (GAAP) is to lay down a framework for
the fair presentation of the financial affairs of a firm. The Canadian and International
frameworks use principles rather than rules, so professional judgment is required when applying
the standards to specific economic situations.
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Firms that purchased financial instruments that fell in value through the Summer and Fall of
2008 made poor investment decisions. The financial reporting of these declines did not cause
the fall in their value. The decrease in their value was the result of market forces and changes in
the supply and demand for these instruments. The financial statements merely reported the
consequences of those external market forces on the value of the assets and liabilities that the
firm continued to hold. As such, the mark-to-market accounting rule did not cause the
economic downturn; it merely reported the effect that the economic downturn was having on
the financial position of those firms that continue to hold those financial instruments.
In the final analysis, AIG’s management made mistakes that caused its collapse, not the mark–to–
market accounting that provided a clear view of the problem. Some people, however, prefer
the head-in-the-sand approach of the ostrich to dealing with their problems.
2. Should the federal government have bailed out AIG, especially when it had not rescued Lehman
Brothers and had let Merrill Lynch be taken over by Bank of America?
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Those who oppose bailouts use the following arguments.
• Private sector firms are inherently risky. Consumer tastes may change, interest rates
may change, and government regulations may change. All of these factors, and many
There are arguments in favor of government bailouts.
• Society is made up of a variety of stakeholders who have an interest in the firm beyond
just the shareholders and creditors. In order to protect the interest of those other
• The government can and does share in both the successes and failures of firms. When a
firm succeeds, the government shares in that success both directly and indirectly –
directly through increased income taxes, and indirectly by having a variable economy
with high employment. When the firm fails, the government suffers through decreased
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Useful Articles, Links, and Videos
Smalera, Paul (July 16, 2010) “AIG settles longstanding fraud cases for $1 billion..” Fortune,
Satow, Julie (April 24, 2009) “AIG’s Six Year Saga of Alleged Fraud.” Huffington Post,
Business & Professional Ethics for Directors, Executives & Accountants, 8e
6. Subprime Lending – Greed, Faith, & Disaster (Chapter 8, pages 650-651)
What this case has to offer
This case allows students to discuss several different ethical issues including:
• the difference between first-best and second-best employment contracts, and
Teaching suggestions
Begin by differentiating between first-best contracts and second-best employment contracts. (A similar
teaching suggestion is made for the ethics case “The Ethics of AIG Commission Sales”.)
• A first-best employment contract occurs when there is a direct link between effort and
outcome, such as commission sales and piecemeal work. If a worker is to be paid for completing
an axle that requires twelve bolts, then the worker is paid for the achievement, rather than the
Discussion of ethical issues
1. Was this an ethically correct sales pitch? Were the lenders taking advantage of financially naive
customers?
Brenkert (1998) argues that the ethics of marketing becomes questionable when the target
audience of the advertising campaign is the more vulnerable members of society. He notes that
there are four types of vulnerability.
• The physically vulnerable are those who have physical ailment or disability and may be
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In the case of the sub-prime mortgages, financial institutions were marketing the mortgages to
the socially vulnerable and the derivate instruments to the intellectually vulnerable. The poor
2. Should the investors now be upset that, as a result of the subprime mortgage meltdown, Merrill’s
stock price fell by about 30 percent in 2007?
Investors know that there is a risk in investing in the stock market but if they have sufficient
information to correctly assess that risk and the ability to act upon their assessment, they
cannot complain about the ethics involved.
3. Are these executive settlements unreasonably high, given the huge financial losses and write-downs
that their companies recorded?
Executive pay is a second-best contract in which the link between effort and outcome is not
always clear. When net income increases, executives often take credit, but when income falls
Arguments can be made in favor of large exit packages.
• The large payout is not usually because the current net income fell. Instead, it is a
reward for the good performance of the executive in the years prior to the current year.
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Arguments can also be made against large payouts.
• The manager is ultimately responsible for the performance of the firm and so should be
accountable in both good and bad times. Since the performance in this period is poor,
the manager should not be rewarded and no large package should be awarded.
Useful Articles, Links, and Videos
Brenkert, G.G. (1998). Marketing and the vulnerable. Business Ethics Quarterly, Ruffin Series 1, 7-21.
Business & Professional Ethics for Directors, Executives & Accountants, 8e
7. Moral Courage: Toronto-Dominion Bank CEO Refuses to Invest in High-Risk
Asset-Based Commercial Paper (Chapter 8, pages 651–653)
What this case has to offer
This case tells the true story of a CEO who demonstrated moral courage by going against conventional
Teaching suggestions
Before getting into the facts of the case, I have the students think about how, as a CEO, you would say
Discussion of ethical issues
1. Did the bank have a moral responsibility to assist in the restructuring of the commercial paper
market?
Carroll (1991) argues that firms have four responsibilities towards society:
• An economic responsibility to remain viable thereby providing the goods and services
required by society.
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2. How would you explain to the board of directors that you were having a bank exit a market in which
your competitors were making a lot of money?
Moral courage is the ability to face problems calmly and with fortitude. It means not
compromising on personal or corporate values. It is demonstrated when a CEO will not sanction
a bad decision on the basis that it may contribute to the short-term profits of the firm. Bad
3. Should the federal government have forced the banks through legislation to providing $950 million
financial support to help solve the ABCP liquidity crisis?
The government has a responsibility to promote the public interest. The central bank is the
government’s vehicle for helping to promote the common good with respect to financial
Useful Articles, Links, and Videos
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8. The Ethics of AIG’s Commission Sales (Chapter 8, pages 653-654)
What this case has to offer
The excessive pay packages given to various employees at firms that subsequently went bankrupt raises
Teaching suggestions
Begin by differentiating between first-best contracts and second-best employment contracts. (A similar
teaching suggestion is made for the ethics case “Subprime Lending – Greed, Faith & Disaster”.)
• A first-best employment contract occurs when there is a direct link between effort and
outcome, such as commission sales and piecemeal work. If a worker is to be paid for completing
an axle that requires twelve bolts, then the worker is paid for the achievement, rather than the
Discussion of ethical issues
1. Ethics of commissions and commission caps
Commissions on sales are first-best contracts. Firms are happy to have these contracts because
revenue increases as sales are made, and a portion of that revenue is given to the sales agent. It
is a win-win scenario. However, most firms prudently wait a period of time before paying
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Business & Professional Ethics for Directors, Executives & Accountants, 8e
Several arguments can be made in favor of no upper limit on sale commissions. If commissions
are capped:
This would not be to the benefit of the firm since the amount of sales to be derived from
commissions would now be capped.
On the other hand, an argument can be made for not remunerating sales agents only by
2. Perks to sales staff
Companies need to guard against making two contradictory assumptions simultaneously. On
the one hand it is assumed that sales agents are only motivated by extrinsic rewards such as
commissions and paid vacations. Meanwhile it is assumed that all the other employees in the
3. Re-hiring managers
Managers develop firm-specific knowledge and skills as a result of working for a firm. Often
these skills are so unique that they are not transferable when an employee leaves and begins to
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The argument for re-hiring managers who caused problems is that those managers have firm-
specific knowledge of the problems since they are the people who caused the problems.
Because of their unique knowledge, they may be in the best position to be able to solve the
problem. If new managers are hired, then it may take some time for the new managers to gain
the firm-specific skills necessary to solve these problems. It may be costly for the firm to invest
Useful Articles, Links, and Videos
“AIG set to repay $37 billion in bailout money.” (November 1, 2010). The Wall Street Journal,
Champ, Henry (October 8, 2008) “Lawmakers fume at excess of failed firm’s execs.” CBC News:
Washington File,