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Legislated Ethics: From Enron
to Sarbanes-Oxley, the Impact
on Corporate America Howard Rockness Joanne Rockness
ABSTRACT. This paper explores the financial reporting
scandals of the past decade and the resulting U.S. legis-
lative attempts to impose ethical behavior and control the
incidence of new reporting problems via the Sarbanes-
Oxley legislation. We begin with a brief historical per-
spective followed by assertions of ethical consequences of
legislation with discussions of key recent corporate scan-
dals, the motives for the frauds, and the consequences.
Ethics related provisions of the Sarbanes-Oxley Act are
discussed with the potential impact of the legislation on
the likelihood of similar future frauds and accompanying
prognosis for future corporate ethical behavior.
KEY WORDS: Corporate culture, corporate ethics,
financial reporting fraud, financial reporting regulation,
internal control, Sarbanes-Oxley Act
Enron, WorldCom, HealthSouth, Adelphia, Par-
malat, Elan, Andersen… the list goes on and on. In the past three years the world economic system has wit-
nessed in monetary terms the largest dollar level of
fraud, accounting manipulations and unethical
behavior in corporate history and certainly the most
economic scandals and failures since the 1920s. Unlike
the Savings and Loan failures of the 1980s, the current
ethical crisis is broadly based and spreads across
industries and countries. In July, 2002 the U.S. Con-
gress responded with the Sarbanes-Oxley Act which
legislates ethical behavior for both publicly traded
companies and their auditor firms. Can a government
legislates ethical behavior or does the corporate or firm
culture determine individual and group actions? This
paper explores that question through review of the
recent corporate scandals along with the requirements
of the Sarbanes-Oxley legislation.
‘‘Historical perspective’’ Section presents a histor-
ical perspective on previous attempts to legislate cor-
porate ethical behavior followed by discussion of some
of the largest recent corporate financial reporting
scandals and the underlying unethical and fraudulent
actions in ‘‘Recent corporate frauds’’ Section. ‘‘Sar-
banes-Oxley Act of 2002’’ section outlines specific
provisions of the Sarbanes-Oxley Act as the most re-
cent attempt to legislate ethical behavior followed by
discussion of the potential outcomes. ‘‘Basic premises
for ethical financial reporting’’ Section of the paper
develops a framework positing four premises of cor-
porate management’s behavior followed by conclu-
sions on the likely impact of the current attempts to
legislate ethical behavior.
Historical perspective
The historical perspective illustrates that the frauds and
failures of recent years are not a new phenomena.
The 20th century witnessed the growth of enormous
international corporations and very large international
Certified Public Accounting (CPA) firms. This
Howard Rockness, Ph.D., is Professor of Accounting at University of
North Carolina – Wilmington. He teaches, conducts research, and
consults in the areas of management control systems, internal controls,
financial reporting, and management accounting. He is involved in
many professional and academic organizations. His research has
appeared in numerous journals including Accounting Review, Jour-
nal of Accounting Research, Accounting, Organizations and Society,
Journal of Information Systems, and Strategic Finance.
Joanne Rockness, Ph.D., CPA is Cameron Professor of Accounting at
University of North Carolina – Wilmington. She teaches, conducts
research, and consults in the areas of business ethics and financial
reporting. She conducts numerous education programs for practicing
professionals on ethics and financial reporting. She chaired the Amer-
ican Accounting Association Committee on Professionalism and Eth-
ics. Her research has appeared in numerous journals including
Accounting, Organizations and Society, Journal of Business Ethics,
Issues in Accounting Education, and Financial Executive.
Journal of Business Ethics 57: 31)54, 2005. � 2005 Springer DOI 10.1007/s10551-004-3819-0
growth has not been without struggle, controversy and
regulation. Corporate fraud, unethical management
behavior, and questionable financial reporting have
surfaced repeatedly throughout the century with
resulting regulation and studies calling for ethical
behavior. Table I presents a summary of key regulatory
acts of the century that attempted to impose ethical
conduct on the U.S. securities markets, corporate
America and the CPA profession. The early legislation
was aimed at financial institutions and the security of
the monetary system. However, the most sweeping
legislation followed the excesses of the 1920s.
The 1920s were a period of industrial growth
with a corresponding surge in stock prices. A new
economy of automobiles, oil, steel, radio commu-
nications and expensive real estate drove market
prices to unprecedented levels (Pearlstein, 2002).
Accounting standards were developed privately, of-
ten poorly defined and unregulated. As a result, they
were subject to manipulation with accurate financial
reporting easily compromised to drive stock prices,
meet loan covenants or attract new investors. The
unregulated securities markets were characterized by
short sales, fraudulent trading practices and margin
purchases that pushed investors and management to
attempt to drive prices in search of even higher re-
turns. The incentives for management to engage in
unethical practices were driven by personal gain, ego
and greed illustrated by opportunistic and exploit-
ative executive behavior to achieve personal objec-
tives. The results were famous frauds such as the
Ponzi scheme, fraudulent financial reporting,
unsubstantiated market values and the crash of 1929.
The Securities Acts of 1933 and 1934 were the U.S.
Congress’ response to the 1920s and the first broadly
based attempt to elicit ethical behavior by corpora-
tions, the securities markets and the accounting pro-
fession through legislation. The Acts established the
U.S. Securities and Exchange Commission (SEC),
regulated securities trading, mandated common
accounting standards and required CPA firm audits of
publicly traded companies. These Acts signified a
landmark change in corporate accountability and
provided the foundation for growth of the CPA
profession as external auditors. Prior to the Sarbanes-
Oxley Act of 2002, the SEC Acts were considered the
most significant pieces of legislation in the history of
both the CPA profession and U.S. corporate financial
reporting.
The 1933 and 1934 SEC Acts did not solve the
systemic problems. Between 1934 and 2002, there
were many instances of ethical transgressions in U.S.
corporate financial reporting. The 1960s were
marked by real estate scandals filled with creative
accounting and the 1970s saw international frauds
and bribery resulting from numerous unethical
behaviors. This time the regulatory response was the
1977 Foreign Corrupt Practices Act. The Act im-
posed new ethical standards on corporations dealing
in foreign countries, attempted to curtail bribery and
illegal payments and precipitated increased audit
procedures (Shearman and Sterling, 2001). The SEC
proposed management attestation of internal control
systems following the Foreign Corrupt Practices Act,
but under pressure from corporate America the
requirement was dropped.
The 1980s experienced the failure of real estate
driven savings and loans as well as widespread Wall
Street corruption, fraudulent reporting, insider
trading and junk-bond schemes (Vickers and France,
2002). By 1991, the FBI had budgeted more than
$125 million to pursue cases of financial fraud in the
S&L industry (U.S. Congress: Senate, 1992) and the
Big Six CPA firms paid $1.6 billion to settle fraud-
ulent reporting charges levied against them by the
federal government (Arthur Andersen et al., 1992).
Zimring and Hawkins (1993) argued that deregula-
tion of banking with relaxation of regulations cre-
ated conditions that made regular fraudulent
practices the norm. The Federal Deposit Insurance
Corporation Improvement Act in 1991 (U.S.
Congress, 1991) dealt directly with the fraud in
savings and loans and required attestation of internal
control in financial institutions. Litigation resulting
from the savings and loan failures precipitated the
Private Securities Litigation Reform Act of 1995
(U.S. Congress, 1995) that attempted to limit CPA
firm liability and was the first requirement for
auditors to report fraud externally to the SEC.
In addition to legislation, unethical actions of the
1970s and 1980s precipitated the National Com-
mission on Fraudulent Financial Reporting (Tread-
way Commission, 1987) report calling for ethical
behavior by corporations. The report made
numerous recommendations to prevent fraudulent
financial reporting including strong
recommendations for internal control systems.
Emphasis was placed on the tone at the top, ethics
32 Howard Rockness and Joanne Rockness
T A
B L E
I
U .S
. le
g is la
ti o n
at te
m p ti n g
to p re
v e n t
b e h av
io rs
v ie
w e d
as u n e th
ic al
L e g is la
ti o n
T im
in g
E th
ic al
fo c u s
R e q u ir
e m
e n t
R e su
lt
O w
e n s-
G la
ss
(F e d e ra
l R
e se
rv e )
A c t
o f
1 9 1 3
1 9 1 3
B an
k in
g fa
il u re
s d u e
to in
ad e q u at
e
o r
fr au
d u le
n t
re se
rv e s
R u le
s fo
r o p e ra
ti o n s
o f
b an
k s
in c lu
d in
g m
ai n te
n an
c e
o f
re se
rv e s,
fi n an
c ia
l re
p o rt
in g
re q u ir
e m
e n ts
C re
at io
n o f
F e d e ra
l R
e se
rv e
S y st
e m
,
in p ar
t, fo
r m
o re
e ff e c ti v e
su p e rv
is io
n
o f
b an
k in
g ac
ti v it ie
s. R
e q u ir
e d
an n u al
in d e p e n d e n t
au d it s
o f
F e d e ra
l R
e se
rv e
B an
k s
an d
B o ar
d
G la
ss -S
te g al
l
A c t
o f
1 9 3 3
1 9 3 3
C o n fl ic
t o f
in te
re st
an d
fr au
d b y
b an
k s
P ro
h ib
it e d
c o m
m e rc
ia l
b an
k s
fr o m
e n g ag
in g
in in
v e st
m e n t
b an
k in
g .
S im
il ar
ly ,
p ro
h ib
it e d
in v e st
m e n t
b an
k s
fr o m
e n g ag
in g
in c o m
m e rc
ia l
b an
k in
g d ir
e c tl y
o r
th ro
u g h
e m
p lo
y e e s,
o ffi
c e rs
, o r
d ir
e c to
rs
In te
n d e d
to k e e p
b an
k s
fr o m
se ll in
g se
c u ri
ti e s
to p ay
o ff
lo an
s m
ad e
b y
th e
b an
k to
fa il in
g c o m
p an
y
o r
c o u n tr
y
U .S
. S e c u ri
ti e s
an d
E x c h an
g e
A c t
o f
1 9 3 3
1 9 3 3
P ro
h ib
it e d
d e c e it ,
m is re
p re
se n ta
ti o n s,
an d
o th
e r
fr au
d in
sa le
o f
se c u ri
ti e s
R e q u ir
e d
d is c lo
su re
o f
re le
v an
t
in fo
rm at
io n
th ro
u g h
re g is tr
at io
n
o f
se c u ri
ti e s
M ad
e c o m
m it m
e n t
o f
fr au
d in
c o n ju
n c ti o n
w it h
sa le
o f
se c u ri
ti e s
(r e g is te
re d
o r
u n re
g is te
re d )
il le
g al
U .S
. S e c u ri
ti e s
an d
E x c h an
g e
A c t
o f
1 9 3 4
1 9 3 4
In si d e r
st o c k
tr ad
in g ,
m an
ip u la
ti o n
o f
fi n an
c ia
l m
ar k e ts
, fr
au d u le
n t
fi n an
c ia
l re
p o rt
in g
S e lf -p
o li c in
g b y
st o c k
e x c h an
g e s
an d
N at
io n al
A ss
o c ia
ti o n
o f
S e c u ri
ty D
e al
e rs
, fi li n g
o f
q u ar
te rl
y
an d
au d it e d
an n u al
re p o rt
s b y
re g is te
re d
c o m
p an
ie s
E st
ab li sh
e d
C P A
as th
e in
d e p e n d e n t
o u ts
id e
au d it o r
o f
p u b li sh
e d
fi n an
c ia
l
st at
e m
e n ts
. P ro
v id
e d
fo r
c iv
il ac
ti o n s
b y
th e
S E
C an
d p ri
v at
e in
v e st
o rs
fo r
fr au
d ,
in si d e r
tr ad
in g ,
an d
m ar
k e t
m an
ip u la
ti o n
In v e st
m e n t
C o m
p an
y
A c t
o f
1 9 4 0
1 9 4 0
A b u se
s in
in v e st
m e n t
c o m
p an
ie s
(p ri
n c ip
al ly
m u tu
al fu
n d s
in v e st
in g
in st
o c k s
o f
o th
e r
c o m
p an
ie s)
in c lu
d in
g c o n fl ic
ts o f
in te
re st
P e ri
o d ic
d is c lo
su re
o f
st ru
c tu
re ,
o p e ra
ti o n s,
fi n an
c ia
l c o n d it io
n ,
an d
in v e st
m e n t
p o li c ie
s E
st ab
li sh
e d
fi d u c ia
ry re
sp o n si b il it
ie s
o f
in v e st
m e n t
c o m
p an
y ’s
d ir
e c to
rs an
d tr
u st
e e s
R e g is tr
at io
n o f
m u tu
al fu
n d
m an
ag e m
e n t
c o m
p an
ie s
an d
d is c lo
su re
o f
tr an
sa c ti o n
b e tw
e e n
th e
m an
ag e m
e n t
c o m
p an
y an
d af
fi li at
e s
F o re
ig n
C o rr
u p t
P ra
c ti c e s
A c t
1 9 7 7
B ri
b e ry
o f
fo re
ig n
g o v e rn
m e n t
an d
b u si n e ss
o ffi
c ia
ls .
U .S
. p o li ti c al
c am
p ai
g n
c o n tr
ib u ti o n s
b y
U .S
. c o rp
o ra
ti o n s
R e q u ir
e d
c o m
p an
ie s
to d e si g n
an d
m ai
n ta
in in
te rn
al c o n tr
o l
sy st
e m
s
an d
d e ta
il e d
re c o rd
s w
h ic
h ac
c u ra
te ly
an d
fa ir
ly re
fl e c t
fi n an
c ia
l ac
ti v it ie
s
M ad
e p ay
m e n ts
to o ffi
c ia
ls o f
fo re
ig n
g o v e rn
m e n t,
c o m
p an
ie s,
o r
th e ir
ag e n ts
in o rd
e r
to o b ta
in b u si n e ss
il le
g al
.
E st
ab li sh
e d
d ir
e c t
li n k
b e tw
e e n
in te
rn al
au d it
fu n c ti o n
an d
b o ar
d
o f
d ir
e c to
rs
Legislated Ethics: From Enron to Sarbanes-Oxley 33
T A
B L E
I
C o n ti n u e d
L e g is la
ti o n
T im
in g
E th
ic al
fo c u s
R e q u ir
e m
e n t
R e su
lt
F ID
C A
im p ro
v e m
e n t
ac t
1 9 9 1
F ra
u d
an d
c o n fl ic
t o f
in te
re st
o n
th e
p ar
t o f
o ffi
c e rs
an d
d ir
e c to
rs o f
fa il e d
sa v in
g s
an d
lo an
in st
it u ti o n s
R e q u ir
e d
re p o rt
b y
o ffi
c e rs
o n
in te
rn al
c o n tr
o l
o v e r
fi n an
c ia
l re
p o rt
in g
an d
c o m
p li an
c e
w it h
fe d e ra
l la
w .
R e q u ir
e d
in d e p e n d e n t
au d it o r
at te
st at
io n
o n
m an
ag e m
e n t
re p o rt
s
o n
in te
rn al
c o n tr
o l
an d
c o m
p li an
c e
F ir
st in
st an
c e
o f
se p ar
at e
m an
ag e m
e n t
as se
rt io
n w
it h
re sp
e c t
to in
te rn
al c o n tr
o l
an d
au d it o r
at te
st at
io n
o f
m an
ag e m
e n t’ s
as se
rt io
n
P ri
v at
e S e c u ri
ti e s
L it ig
at io
n R
e fo
rm
A c t
1 9 9 5
F ri
v o lo
u s
li ti g at
io n
ag ai
n st
S E
C
c o m
p an
ie s
fo r
al le
g e d
w ro
n g -d
o in
g
R e q u ir
e d
la w
y e r
to m
ak e
sp e c ifi
c
al le
g at
io n s
o f
w ro
n g -d
o in
g b u t
al so
re q u ir
e d
o u ts
id e
au d it o r
to n o ti fy
S E
C o f
se ri
o u s
fi n an
c ia
l w
ro n g d o in
g
O u ts
id e
au d it o r
m u st
re p o rt
e v id
e n c e
o f
se ri
o u s
fi n an
c ia
l w
ro n g d o in
g to
b o ar
d o f
d ir
e c to
rs an
d th
e n
to S E
C
if b o ar
d d o e s
n o t
ta k e
ap p ro
p ri
at e
ac ti o n
S ar
b an
e s-
O x le
y
A c t
(S e e
T ab
le IV
fo r
d e ta
il e d
an al
y si s
o f
c o n te
n t)
2 0 0 2
F ra
u d u le
n t
fi n an
c ia
l re
p o rt
in g
R e g u la
te s
C P A
p ro
fe ss
io n
an d
se rv
ic e
p ro
v id
e d
to e x te
rn al
p u b li c
c o m
p an
y au
d it
c li e n ts
, an
d
le g is la
te s
c o n tr
o l
re q u ir
e m
e n ts
,
c o rp
o ra
te m
an ag
e m
e n t
c e rt
ifi c at
io n s,
au d it
c o m
m it te
e s
re sp
o n si b il it ie
s,
an d
c o rp
o ra
te c u lt u re
c h an
g e s
S ig
n ifi
c an
t c iv
il an
d c ri
m in
al p e n al
ti e s
fo r
c e rt
ifi c at
io n
b y
m an
ag e m
e n t
o f
in ac
c u ra
te fi n an
c ia
l st
at e m
e n ts
o r
in o p e ra
ti v e
in te
rn al
c o n tr
o ls . E
st ab
li sh
e d
in c re
as e d
o v e rs
ig h t
re sp
o n si b il it ie
s
fo r
au d it
c o m
m it te
e s
o f
b o ar
d o f
d ir
e c -
to rs
. R
e q u ir
e s
e x te
rn al
au d it o r
c e rt
ifi c a-
ti o n
o f
in te
rn al
c o n tr
o ls
34 Howard Rockness and Joanne Rockness
education and codes of conduct. However, the
Treadway Commission focused more on employee
fraud, not management fraud, and centered on
detection, not prevention, providing no clear
effective strategy for preventing management fraud
(Tipgos, 2002). Following the Treadway Report,
the SEC once again proposed management attesta-
tion of internal control systems as well as disclosure
of responses to auditor recommendations, but they
backed down under pressure from corporate
America. In 1992, the Committee of Sponsoring
Organizations of the Treadway Commissions
(COSO, 1992) again responded to the ethical
problems of the 1980s with their framework for
internal control framework guidance.
The 1990s brought an unprecedented era of
fraudulent reporting and unethical corporate man-
agement behavior. The dot.com phenomena, a new
economy of technology, communications, day-
trading, a roaring bull market, and a surge of initial
public offerings often creating instant wealth made
this period unlike any time in history. The use of
incentive-based compensation schemes provided the
incentives, and continued development of computer
technology and the transfer of records from paper to
machine paved the way to countless opportunities
for fraudulent financial reporting.
A new round of corporate failures began in the
late 1990s and early 2000s. The unethical actions of
corporate leaders led to bankruptcies and restate-
ments of a magnitude unimagined in prior decades.
Since 1997, more than 10% of U.S. public compa-
nies have restated their reports resulting in market
capitalization losses in excess of $100 billion (GAO,
2002). In the twelve-month period ending June 30,
2003 alone, 354 companies restated earnings (Huron
Consulting Group, 2003). The sheer size of the
failures dwarfed previous scandals. ‘‘It is not that our
leaders are worse than ever, it’s just that the bad ones
can do more damage than ever before, and on a
spectacular scale’’ (Morris, 2002).
The response this time was the Sarbanes-Oxley
legislation (Sarbanes) of 2002, which is the focus of
this paper and is discussed in detail in ‘‘Conclusion’’
Section. Will Sarbanes be different or will unethical
and fraudulent management behavior continue
resulting in more corporate failures? The parallels of
the 1920s, the 1980s and the past decade are strong
and raise serious doubts as to whether ethical
behavior can be legislated. ‘‘Recent corporate
frauds’’ Section discusses some of the most glaring
illustrations of ethical misconduct and fraud in cor-
porate America to set the stage for U.S. legislature’s
perceived need to respond with the Sarbanes-Oxley
Act in 2002.
Recent corporate frauds
‘‘Losses from financial frauds total approximately $200
billion dollars. On Enron alone those losses are more
than two times the aggregate losses suffered when the
stock market crashed in 1929.’’ (Turner, 2002)
Enron
Enron’s failure will most likely go down in history as
not only one of the most spectacular financial fail-
ures, but also as a turning point in professional
accounting regulation and corporate financial
reporting. It was the driving force behind the Sar-
banes-Oxley legislation. However, it was only one
of many corporate failures resulting from unethical
and fraudulent behavior that led to landmark legis-
lation.
Table II presents a summary of significant recent
corporate and accounting frauds. The unethical
behaviors represented in Table II include fraudulent
financial reporting (most common), obstruction of
justice, theft of assets, unauthorized loans to senior
management, bribery, manipulation of markets,
perjury, and insider trading. The types of fraud were
pervasive, extended over years rather than single
episodes, and involved very large sums of money.
The most consistent common element across all
these firms is the involvement of senior management
in the frauds including members of the Board of
Directors, the CEO, the CFO, and other key
executives.
The tone at the top has been cited as the pri-
mary driver of corporate ethical conduct by many
professional sources (e.g., AICPA, 2002; COSO,
1992; Treadway Commission, 1987). Ethicists have
long argued that tone drives the corporate culture
(Buchholz and Rosenthal, 1998, p.177). Sweeney
(2003) argued that the tone at the top sets the
corporate culture and in many cases was a root
cause of the unethical conduct and fraudulent
Legislated Ethics: From Enron to Sarbanes-Oxley 35
T A
B L E
II
E x am
p le
c o m
p an
ie s
c h ar
g e d
w it h
fi n an
c ia
l ir
re g u la
ri ti
e s
C o m
p an
y In
d u st
ry F ra
u d
A c ti v it y
P ar
ti c ip
an ts
O u tc
o m
e
S u n b e am
– 1 9 9 6 – 1 9 9 7
($ 6 0
m il li o n )
C o n su
m e r
d u ra
b le
s
F ra
u d u le
n t
fi n an
c ia
l
re p o rt
in g
U n d e rs
ta ti n g
in v e n to
ry v al
u e ,
u n d e rr
e p o rt
in g
c o st
o f
g o o d s
so ld
,
re c o g n iz
in g
re v e n u e
fr o m
u n d e li v e re
d
g o o d s,
b il l
an d
h o ld
sa le
s, c h an
n e l
st u ffi
n g ,
an d
e st
ab li sh
in g
fa ls e
re se
rv e s
in 1 9 9 6
to
im p ro
v e
1 9 9 7
in c o m
e
S e n io
r m
an ag
e m
e n t
in c lu
d in
g C
E O
C E
O an
d C
F O
se tt
le d
S E
C c iv
il c h ar
g e s
, te
rm i-
n at
io n
o f
se n io
r m
an ag
e -
m e n t,
b ar
re d
fr o m
se rv
in g
in se
n io
r p o si ti o n s
in
p u b li c
c o m
p an
ie s
W as
te m
an ag
e m
e n t
– (1
9 9 7 )
($ 1 .7
b il li o n )
T ra
sh
c o ll e c ti o n
an d
d is p o sa
l
F ra
u d u le
n t
fi n an
c ia
l
re p o rt
in g
M is re
p re
se n ta
ti o n
o f
as se
t li v e s
an d
sa lv
ag e
v al
u e s,
o v e rv
al u at
io n
o f
la n d fi ll
si te
as se
ts ,
e x c e ss
re se
rv e s,
an d
re p o rt
in g
e x p e n se
s
as as
se ts
S e n io
r m
an ag
e m
e n t
S e n io
r m
an ag
e m
e n t
su e d
fo r
fr au
d ,
se tt
le d
in si d e r
tr ad
in g
c h ar
g e .
C o m
p an
y
se tt
le d
c iv
il li ti g at
io n
fo r
$ 4 5 7
m il li o n .
G lo
b al
c ro
ss in
g
(2 0 0 2 )
T e le
c o m
m u n ic
at io
n s
F ra
u d u le
n t
fi n an
c ia
l
re p o rt
in g
O v e rs
ta te
m e n t
o f
re v e n u e
fr o m
b ar
te r
tr an
sa c ti o n s
S e n io
r m
an ag
e m
e n t
C h ap
te r
1 1
b an
k ru
p tc
y ,
c o n g re
ss io
n al
in v e st
ig a-
ti o n ,
S E
C c h ar
g e d
se n io
r
m an
ag e m
e n t
w it h
fr au
d
X e ro
x –
(1 9 9 7 – 2 0 0 0 )
($ 1 .5
b il li o n )
O ffi
c e
E q u ip
m e n t
F ra
u d u le
n t
fi n an
c ia
l
re p o rt
in g
B o o k in
g re
v e n u e
fr o m
fo re
ig n
su b si d ia
ri es
b ef
o re
e ar
n e d
an d
fa il u re
to
ap p ro
p ri
at e ly
c la
ss if y
le as
e as
se ts
S e n io
r m
an ag
e m
e n t
fo r
S o u th
A m
e ri
c a
$ 1 0
m il li o n
fi n e
W o rl
d C
o m
/ M
C I
-( 2 0 0 2 )
($ 3 .8
b il li o n
in c o m
e an
d $ 4 0 0
m il li o n
in lo
an s,
al le
g e d
$ 1 1
b il li o n
in re
v e n u e )
T e le
c o m
m u n ic
at io
n s
F ra
u d u le
n t
fi n an
c ia
l
re p o rt
in g
R e p o rt
in g
o f
li n e
re n ta
l
e x p e n se
as c ap
it al
le as
e
as se
t, u n d e rr
e p o rt
in g
o f
li n e
re n ta
l e x p e n se
s, an
d
o ff -b
o o k s
lo an
s to
C E
O
S e n io
r m
an ag
e m
e n t
C E
O c h ar
g e d
w it h
fr au
d ,
C F O
an d
o th
e r
fi n an
c ia
l
e x e c u ti v e s
p le
ad g u il ty
to
c ri
m in
al fr
au d ,
ac ti v e
ja il
se n te
n c e s
36 Howard Rockness and Joanne Rockness
A n d e rs
e n
(2 0 0 2 )
O b st
ru c ti o n
o f
ju st
ic e
D e st
ru c ti o n
o f
d o c u m
e n ta
ry e v id
e n c e
af te
r S E
C la
u n c h
o f
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n in
v e st
ig at
io n
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e n
le g al
d e p ar
tm e n t
an d
p ro
fe ss
io n al
st af
f
C o n v ic
te d
o f
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ru c ti o n
o f
ju st
ic e
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m d is so
lv e d
H e al
th so
u th
(2 0 0 3 )
($ 4 .2
b il li o n
o v e rs
ta te
m e n t
o f
in c o m
e )
H e al
th c ar
e
d e li v e ry
F ra
u d u le
n t
fi n an
c ia
l
re p o rt
in g
R e p o rt
in g
n o n -e
x is ta
n t
as se
ts an
d u n d e r
re p o rt
in g
re v e n u e s
S e n io
r m
an ag
e m
e n t
G u il ty
p le
as b y
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2 5
o f
se n io
r fi n an
c ia
l m
an ag
e rs
,
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O c h ar
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w it h
c iv
il
an d
8 5
c o u n ts
o f
c ri
m in
al
fr au
d
T y c o
(2 0 0 2 )
($ 6 0 0
m il li o n )
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e rs
ifi e d
m an
u fa
c tu
re r
T h e ft
o f
as se
ts ,
u n au
th o ri
ze d
lo an
s to
se n io
r
m an
ag e m
e n t,
an d
fr au
d u le
n t
fi n an
c ia
l re
p o rt
in g
U n au
th o ri
z e d
lo an
s an
d
p ay
m e n ts
to se
n io
r
e x e c u ti v e s
S e n io
r m
an ag
e m
e n t
in c lu
d in
g C
E O
, C
F O
,
an d
c h ie
f le
g al
o ffi
c e r
S e n io
r m
an ag
e m
e n t
in d ic
te d
fo r
c o rr
u p ti o n ,
c o n sp
ir ac
y ,
g ra
n d
la rc
e n y
an d
fa ls if y in
g re
c o rd
s.
C E
O an
d C
F O
p le
ad e d
in n o c e n t.
S ix
m o n th
tr ia
l e n d e d
w it h
h u n g
ju ry
A d e lp
h ia
C o m
m u n ic
at io
n s
2 0 0 1
($ 3 .1
b il li o n
in c lu
d in
g $ 3 0 0
in
u n au
th o ri
ze d
c as
h
w it h d ra
w al
s an
d lo
an s
b y
fo u n d in
g fa
m il y / se
n io
r
m an
ag e m
e n t)
C ab
le
te le
v is io
n
T h e ft
o f
as se
ts
F ra
u d u le
n t
fi n an
c ia
l re
p o rt
in g
U n au
th o ri
z e d
p ay
m e n ts
an d
lo an
s to
p ri
n c ip
le
o w
n e rs
, in
fl at
e d
c ap
it al
e x p e n d it u re
s, h id
d e n
d e b tF
o u n d in
g fa
m il y / se
n io
r
m an
ag e m
e n t
S E
C / D
e p ar
tm e n t
o f
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tm e n t
P ar
m al
at 2 0 0 3
(e st
im at
e d
8 .0
b il li o n
e u ro
s o v e rs
ta te
m e n t
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ts an
d
5 0 0
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e u ro
s
d iv
e rt
e d
to fa
m il y
ac c o u n ts
)
D ai
ry
p ro
d u c ts
F ra
u d u le
n t
fi n an
c ia
l
re p o rt
in g ,
lo o ti n g
o f
c o m
p an
y
R e p o rt
in g
n o n -e
x is te
n t
as se
ts (C
as h )
F o u n d e r/
fa m
il y / se
n io
r
m an
ag e m
e n t
A h o ld
N V
-2 0 0 3
(O v e r
st at
e m
e n t
o f
in c o m
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at
le as
t 9 0 0
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e u ro
s)
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c e ri
e s
an d
fo o d
d is tr
ib u ti o n
M an
ag e m
e n t
fr au
d
in S an
d E
u ro
p e an
su b si d ia
ri e s
O v e rs
ta ti n g
in c o m
e in
su b si d ia
ri e s
in p ar
t b y
re c o g n iz
in g
m an
u fa
c tu
re r
re b at
e s
an d
sp e c ia
l
d is c o u n ts
p ri
o r
to sa
le
o f
g o o d s
S u b si d ia
ry m
an ag
e m
e n t
C E
O an
d C
F O
o f
c o m
p an
y re
si g n
Legislated Ethics: From Enron to Sarbanes-Oxley 37
activities. He cites two common characteristics:
overly aggressive financial performance targets and
a can-do culture that did not tolerate failure
(Sweeney, 2003).
In this culture, what often began as questionable
accounting adjustments grew into massive fraud in
an attempt to fix each quarter’s numbers to close the
variance between income targets and actual results.
The classic slippery slope of unethical behavior
prevailed as otherwise honest people came to be-
lieve they were acting in the best interest of the
company and consented to participating in unethical
and fraudulent behavior. Personal gain, ego and
survival were perhaps all motivating factors for the
individuals involved. The impact of senior man-
agement on the corporate culture and resulting
frauds are illustrated by taking a closer look at three
of the biggest scandals: Enron, WorldCom, and
HealthSouth.
Sims and Brinkman (2003) provide an in-depth
analysis of the culture at Enron. They describe how
Jeffrey Skilling, former CEO, set the tone at the top
by creating a culture that would push limits and
where employees were expected to perform to a
continually increasing standard. Bartlett and Glinska
(2001) quoted employees stating ‘‘. . .it was all about an atmosphere of deliberately breaking the rules. . .’’ Complex accounting strategies and manipulations
were utilized to meet ever-higher expectations.
The Enron issues were relatively sophisticated
requiring knowledge of difficult accounting regu-
lations and an understanding of ways to manipulate
the rules. Approximately 3000 non-consolidated
special purpose entities were created to move debt
off the balance sheet, complicated hedge and
derivative transactions were improperly accounted
for, related party transactions were improperly dis-
closed (or not disclosed at all), and the accounting
for the sale of Enron’s stock in exchange for notes
receivable was questionable.
Enron’s slippery slope got steeper. It started as
utilization of accounting rules to the company’s
advantage. It then progressed to fraudulent report-
ing and, finally, to destruction of documents.
Numerous people were involved with many having
full knowledge of the fraudulent accounting. One
mid-level executive, Sherron Watkins, tried to blow
the whistle but was ignored (Morse and Bower,
2002). Control systems failures were evident in both
T A
B L E
II
C o n ti n u e d
C o m
p an
y In
d u st
ry F ra
u d
A c ti v it y
P ar
ti c ip
an ts
O u tc
o m
e
C e n d an
t D
iv e rs
ifi e d
se rv
ic e s
E n ro
n
(O v e r
$ 1
b il li o n )
E n e rg
y F ra
u d u le
n t
fi n an
c ia
l
re p o rt
in g ,
b ri
b e ry
o f
fo re
ig n
g o v e rn
m e n t
o ffi
c ia
ls ,
m an
ip u la
ti o n
o f
e n e rg
y m
ar k e ts
O v e rs
ta ti n g
in c o m
e
b y
h id
in g
lo ss
e s,
an d
u n d e rs
ta te
m e n t
o f
li ab
il it ie
s
b y
tr an
sf e rr
in g
d e b t
to
re la
te d
c o m
p an
ie s
S e n io
r m
an ag
e m
e n t
G u il ty
p le
as b y
se n io
r
fi n an
c ia
l m
an ag
e m
e n t,
in d ic
tm e n t
o f
C E
O
Im c lo
n e
S y st
e m
s
In c .
2 0 0 2
B io
te c h n o lo
g y /
P h ar
m ac
e u ti c al
s
In si d e r
tr ad
in g ,
p e rj
u ry
, in
si d e r
tr ad
in g ,
an d
o b st
ru c ti o n
o f
ju st
ic e
S al
e o f
o w
n e d
sh ar
e s
b y
se n io
r m
an ag
e m
e n t
ah e ad
o f
an n o u n c e m
e n t
o f
b ad
n e w
s
S e n io
r m
an ag
e m
e n t,
fa m
il y ,
an d
fr ie
n d s
C E
O p le
ad e d
g u il ty
,
fr ie
n d
c o n v ic
te d
38 Howard Rockness and Joanne Rockness
the corporation and in their external audit firm,
Andersen, as the warnings of Sherron Watkins and
others within Andersen went unheeded. The result
was the then largest corporate bankruptcy of the
century and the resulting demise of Andersen.
Unprecedented levels of Enron related litigation
are underway including lawsuits brought by inves-
tors, the SEC, the U.S. Justice Department, pension
plans, and employees (SEC, 2004a). Major invest-
ment firms including Citibank and J.P Morgan al-
ready have paid $135 million and $120 million,
respectively, to settle SEC charges that they aided
Enron in the fraud (Forbes, 2003). Fifteen former
executives were criminally indicted and seven have
pleaded guilty. Andrew Fastow, the former CFO,
pleaded guilty to fraud in January 2004 and negoti-
ated a ten-year prison sentence (CNN Money,
2004). He will be a major witness against the former
CEO Jeffrey Skilling. On February 19, 2004, the
U.S. Justice Department charged Skilling with 42
counts conspiracy, fraud, and other security laws
violations (Flood, 2004).
WorldCom
At WorldCom, CEO and founder, Bernie Ebbers,
set the tone at the top. Richard Breeden, former
chairman of the SEC, says Ebbers ‘‘scoffed at ethics
and controls. . .real men only worry about revenue growth’’ (Sweeney, 2003). In the WorldCom cul-
ture, promotions were given to those who claimed
credit for things they did not do, were willing to
twist reality, and promised what they could not
deliver. Trouble began at WorldCom when they
failed to meet the revenue expectations commu-
nicated earlier to the investment community. In
2004, the CFO pleaded guilty stating that he and
the CEO met concerning the problem. The CEO
refused to meet with the investment community to
announce the shortfall. Rather, the CFO said he
was instructed by the CEO to fix the problem.
Allegations are that the CEO was keenly aware of
the likely impact on share price and was more
concerned about $400 million he had personally
borrowed from WorldCom secured by WorldCom
stock (Padgett, 2002).
The WorldCom unethical and fraudulent
accounting practices resulted in a $9 billion dollar
restatement… the largest in U.S. history. Recent evidence now places the total fraudulent reporting
at $11 billion (Perrotta, 2004). Over a five-year
period, accountant’s at WorldCom systematically
altered records, often after the books were closed,
to meet analyst’s expectations. According to the
WorldCom indictment, CEO Ebbers, CFO Sulli-
van and others created a process called ‘‘close the
gap’’ which identified improper accounting
adjustments and then instructed staff to carry out
the manipulations. Initially reserves were used to
absorb expenses. When the reserves ran out a
variety of accounting frauds were used to enhance
revenues and decrease expenses. For example, costs
for annual operating leases for lines were capitalized
as assets to reduce expenses (SEC, 2004b). Unlike
Enron, this did not involve manipulation of com-
plex accounting rules, but rather a straight-forward
capitalization of expenses.
Members of the financial staff including the CFO,
the controller and head of general accounting have
pleaded guilty to fraud and the CEO has been
charged with securities fraud (Washington Post,
2004). David Myers the former controller told a
U.S. district judge that he was ‘‘instructed on a
quarterly basis by senior management to ensure that
entries were made to falsify WorldCom’s reported
actual costs and therefore increase WorldCom’s re-
ported earnings. ‘‘I knew there was no justification
or documentation’’ (Taub, 2002). Accounting
managers were given promotions, raises, and made
to feel responsible for the likely collapse of the stock
price if they did not manipulate the books (Pulliam,
2003).
The WorldCom corporate culture encouraged
unethical behavior both by appealing to individ-
uals’ sense of promoting the greatest common
good for the workers, shareholders, and commu-
nity and by raising fears of losing their jobs if they
did not comply with requests to falsify records.
Arguably, many of the financial staff at Enron may
not have had the knowledge to recognize the
sophisticated transactions as fraudulent. However,
WorldCom staff knew it was wrong and went
along with the schemes anyway (Pulliam, 2003).
Again, an individual, Cynthia Cooper, blew the
whistle to the audit committee and started the
resulting disclosure of the fraudulent financial
practices (Ripley, 2002).
Legislated Ethics: From Enron to Sarbanes-Oxley 39
HealthSouth
HealthSouth is perhaps the most egregious illustra-
tion of unethical and fraudulent behavior. Recent
estimates indicate the accounting fraud may have
manufactured $4 billion of false earnings (MSNBC,
2004). Once again, the tone at the top led to a
slippery slope of unethical actions. According to the
SEC indictment, senior officers would present actual
results to the CEO each quarter and, if they were
short of expectations, he would tell them to fix it.
The accounting personnel then convened in ‘‘family
meetings’’ and discussed what false accounting en-
tries to make to inflate earnings. The focus was on
altering the contractual adjustments account (com-
mon in health care to recognize differences between
gross billings and what health care providers will
pay) to increase net revenue. The adjustment was
balanced by falsifying fixed assets accounts. To fur-
ther the fraud, many of HealthSouth’s accounting
personnel were prior employees of the auditor, Ernst
and Young, and knew adjustments they could make
that would not be detected in audit procedures. If
the auditors did question an entry, the HealthSouth
accountants created false documents to support it
(SEC, 2003c). The CEO Scrushy personally profited
selling 7.7 million shares of stock when the price was
artificially inflated by accounting numbers as well as
bonus payments and salary payments.
HealthSouth’s ethical problems also existed at the
Board level. Three directors’ had significant ties to
the company: one earned $250,000 in consulting
fees, one owned expensive resort property with the
CEO, and one had a $5.6 million contract to install
glass at a HealthSouth hospital. The same three
served on the combined audit and compensation
committee (Lublin and Carms, 2003).
The SEC accused former HealthSouth manage-
ment of fabricating $2.74 billion in earnings and
charged them with fraud, reporting violations, and
internal controls violations. Fifteen financial
employees have pleaded guilty. Scrushy has been
indicted on 85 counts and he has pleaded not-guilty
(Bassing, 2003). Scrushy was the first CEO to be
charged under the Sarbanes-Oxley Act for signing a
false certification of financial statements. Scrushy’s
attorneys have fought the charge with a rebuttal that
Sarbanes is unconstitutional and should be repealed
(National Accounting News, 2003). Meanwhile,
Scrushy has become a religious talk show host
(CBSNEWS, 2004).
All three of these cases illustrate a corrupt tone at
the top that emphasized making the numbers at the
expense of doing the right thing. Collusion, top
management pressure on employees to act unethi-
cally, personal greed and gain, audit failures, and a
corrupt corporate culture were common across these
corporations. Similar patterns can be seen in the
other companies listed in Table II. Is it possible for
legislation to prevent further unethical and fraudu-
lent behavior in corporations like we have witnessed
in these cases? The U.S. Congress has attempted to
do so with the Sarbanes-Oxley legislation of 2002.
However, the regulations are aimed not only at
corporate America but also at the CPA firms who
perform their audits. The major international CPA
firms have demonstrated similar ethical problems.
Before we discuss the specific provisions of the
Sarbanes Act, we present a brief review of the most
notable recent ethical issues raised by actions of CPA
firms.
The big five. . .no, the final four: ethical failure in CPA firms
‘‘Too many CFO’s are being judged today not by how
effectively they manage operations, but by how they
manage the street. And, too many auditors are being
judged not just by how well they manage an audit, but
by how well they cross-market their firm’s non-audit
services.’’ (Levitt, 2000)
The corporate ethical failures of the past decade have
taken their toll on the U.S. public accounting pro-
fession. Table III links a number of the major
financial reporting scandals to their respective
external auditors along with the related litigation
against the CPA firms. One conclusion that may be
drawn from Table III is that none of the firms have
been immune from scandal and all have been subject
to litigation.
All of the Big Five were subject to criticism in the
1990s for inadequate audit procedures, a strong focus
on increasing the breadth and volume of consulting
services, providing internal audit services to external
audit clients, and utilizing the accounting rules to the
40 Howard Rockness and Joanne Rockness
T A
B L E
II I
S am
p le
o f
re c e n t
C P A
fi rm
in v o lv
e m
e n ts
in fi n an
c ia
l ir
re g u la
ri ti e s
F ir
m C
li e n t
C h ar
g e
O u tc
o m
e
A n d e rs
e n
(1 9 9 7 )
W as
te m
an ag
e m
e n t
S E
C :
F al
se an
d M
is le
ad in
g au
d it
re p o rt
s P ai
d $ 2 5 6
m il li o n
th re
e p ar
tn e rs
ag re
e d
to an
ti -f
ra u d
in ju
n c ti o n ,
a c iv
il p e n al
ty an
d a
b ar
fr o m
ap p e ar
in g
o r
p ra
c ti c in
g in
fr o n t
o f
th e
S E
C as
an ac
c o u n ta
n t
C o m
p an
y se
tt le
d c la
ss ac
ti o n
fo r
$ 4 5 7
m il li o n
A n d e rs
e n
(1 9 9 6 – 1 9 9 7 )
S u n b e am
S h ar
e h o ld
e r
S u it :
C o n c e al
in g
m at
e ri
al ad
v e rs
e
n o n -p
u b li c
in fo
rm at
io n
fr o m
th e
p u b li c
P ai
d $ 1 1 0
m il li o n . N
o ad
m is si o n
o f fr
au d
o r
li ab
il it y .
A n d e rs
e n
(2 0 0 2 )
E n ro
n D
e st
ru c ti o n
o f
d o c u m
e n ts
, o b st
ru c ti
o n
o f
ju st
ic e
P ai
d $ 4 0
m il li o n
in sh
ar e h o ld
e r
su it
C o n v ic
te d
o f
o b st
ru c ti o n
o f
ju st
ic e
F ir
m d is so
lv e d
A n d e rs
e n
(2 0 0 2 )
W o rl
d c o m
/ M
C I
Im p ro
p e r
au d it
p ro
c e d u re
s C
o u rt
h e ld
A n d e rs
e n
w o u ld
h av
e u n c o v e re
d fr
au d
if it
h ad
d o n e
re q u ir
e d
re v ie
w p ro
c e d u re
s,
au d it
o p in
io n s
m at
e ri
al ly
m is re
p re
se n te
d
c o m
p an
y fi n an
c ia
l p o si ti o n
E rn
st an
d y o u n g
(2 0 0 3 – 2 0 0 4 )
H e al
th so
u th
S h ar
e h o ld
e r
S u it :
A ll e g e s
au d it o rs
k n e w
ab o u t
th e
fr au
d u le
n t
ac c o u n ti n g
In v e st
ig at
io n
in p ro
c e ss
E rn
st an
d Y
o u n g
(2 0 0 3 )
P ri
v at
e ta
x c li e n ts
C re
at e d
an d
m ar
k e te
d al
le g e d
il le
g al
ta x
sh e lt e rs
P ai
d $ 1 5
m il li o n
to se
tt le
a U
.S .
In te
rn al
R e v e n u e
S e rv
ic e
in v e st
ig at
io n
in to
it s
sa le
o f
ta x
sh e lt e rs
E rn
st an
d Y
o u n g
(2 0 0 3 )
P e o p le
so ft
S E
C ’s
c o n fl ic
t o f
in te
re st
c h ar
g e s
an d
la c k
o f
in d e p e n d e n c e
in so
ft w
ar e
in st
al la
ti o n s
S E
C so
u g h t to
b ar
E an
d Y
fr o m
ac c e p ti n g
n e w
p u b li c ly
tr ad
e d
c li e n ts
, re
p ay
fe e s O
n g o in
g in
v e st
ig at
io n
E rn
st an
d Y
o u n g
(2 0 0 3 )
A m
e ri
c an
e x p re
ss ,
A m
e ri
c an
ai rl
in e s,
C o n ti n e n ta
l ai
rl in
e s
C o n fl ic
t o f
in te
re st
an d
p o te
n ti al
la c k
o f
in d e p e n d e n c e
re su
lt in
g fr
o m
‘‘ p ro
fi t
sh ar
in g ’’
u n d e r
e x c lu
si v e
tr av
e l
c o n tr
ac ts
O n g o in
g in
v e st
ig at
io n
E rn
st an
d Y
o u n g
(2 0 0 3 )
N e x tc
ar d
in c .
O b st
ru c ti o n
o f
Ju st
ic e
an d
A lt e ra
ti o n
an d
d e st
ru c ti o n
o f
d o c u m
e n ts
C iv
il an
d c ri
m in
al c h ar
g e s
ag ai
n st
E an
d Y
e m
p lo
y e e s
G u il ty
p le
a b y
o n e
e m
p lo
y e e
K P M
G (1
9 9 7 )
X e ro
x S E
C c h ar
g e d
fo u r
K P M
G p ar
tn e rs
w it h
fr au
d .
A ll e g e
fr au
d u le
n tl y
al lo
w e d
c o m
p an
y to
m an
ip u la
te ac
c o u n ti n g
p ra
c ti c e s
to fi ll
a $ 3
b il li o n
g ap
b e tw
e e n
ac tu
al an
d re
p o rt
e d
re su
lt s
K P M
G d e n ie
s c h ar
g e s
an d
re b u tt
in g
in c o u rt
K P M
G (2
0 0 3 )
P ri
v at
e ta
x c li e n ts
C re
at e d
an d
m ar
k e te
d al
le g e d
il le
g al
ta x
sh e lt e rs
O n g o in
g in
v e st
ig at
io n
P W
C (2
0 0 3 )
S m
ar T
al k
te le
se rv
ic e s
in c
S E
C an
n u al
re p o rt
c o n ta
in e d
m at
e ri
al ly
fa ls e
an d
m is le
ad in
g fi n an
c ia
l st
at e m
e n ts
P ai
d $ 1
m il li o n
n e it h e r
ad m
it te
d n o r
d e n ie
d
w ro
n g d o in
g
P W
C (2
0 0 0 )
M ic
ro st
ra te
g y
F ra
u d u le
n t
ac c o u n ti n g
T h re
e to
p e x e c u ti v e s
fi n e d
P W
C n o t
c h ar
g e d
D e lo
it te
(2 0 0 3 – 2 0 0 4 )
P ar
m al
at F ra
u d u le
n t
fi n an
c ia
l re
p o rt
in g
O n -g
o in
g
D e lo
it te
(2 0 0 3 )
R e li an
c e
In su
ra n c e
C o m
p an
y
K n e w
o f
c o m
p an
y c o n d it io
n p ri
o r
to si g n in
g
au d it ,
c o n tr
ib u te
d to
fa il u re
O n -g
o in
g D
e lo
it te
d e n ie
s c h ar
g e s
D e lo
it te
(2 0 0 3 )
M an
h at
ta n
In v e st
m e n t
F u n d
Im p ro
p e r
au d it
p ro
c e d u re
s P ai
d $ 3 2
m il li o n
in se
tt le
m e n t
Legislated Ethics: From Enron to Sarbanes-Oxley 41
advantage of audit clients rather than focusing on
underlying economic substance. Articles in the
business press such as ‘‘AccountingWars’’ (Business
Week, 2000), ‘‘Lies, Damned Lies, and Managed
Earnings’’ (Fortune, 1999) became widespread.
Arthur Levitt, then chairman of the SEC, repri-
manded the CPA profession for flaws in revenue
recognition practices, utilization of ‘‘cookie-jar’’
reserves, and capitalization of in-process R&D. He
also expressed strong concerns about a perceived
lack of independence (Levitt, 1998). Based on his
concerns, Levitt predicted an Enron, just not spe-
cifically by name (Business Week, 2000). Arthur
Wyatt, a former FASB member, argued that greed
became a driving force within the accounting firms
just as it did within many corporations. He further
argued, ‘‘the cultures of the firms – changed from a
central emphasis on delivering professional services
in a professional manner to an emphasis on growing
revenues and profits’’ (Wyatt 2004, p. 49).
In June of 2000, the SEC believed that the po-
tential for ethical failures was sufficient to justify
proposing new regulations on auditor independence
to impose limits on services to audit clients to avoid
conflicts of interest. The proposal would have ban-
ned external auditors from providing the same non-
audit services to audit clients that Sarbanes banned
two years later (Business Week, 2000). The proposal
met with strong opposition from the Big Five, the
American Institute of Certified Public Accountants
(AICPA), and corporate America and resulted in a
compromise regulation in November, 2000 which
permitted information systems design and imple-
mentation consulting as well as limited internal audit
outsourcing to continue as long as fees were dis-
closed. The Sarbanes-Oxley Act of 2002 subse-
quently has prohibited these services.
Under the 2000 SEC regulations, Andersen
continued providing significant consulting services
to Enron in addition to external audit services. Total
Enron-based revenue was $55 million in 2000 with
$27 million from consulting services. As Enron
collapsed, so did Andersen. Within six months of the
Enron bankruptcy filing, Andersen was found guilty
of obstruction of justice but they also admitted fail-
ures in internal processes to ensure quality audits and
professional integrity (Hecht, 2003). The tone at the
top and culture in Andersen had parallels to the
previously discussed corporate cultures. Andersen
had placed great emphasis on growth with evidence
suggesting that client satisfaction and growth may
have been more important than ethical financial
reporting (Byrne, 2002).
The remaining Big Four continue to have ethical
and financial reporting problems. A critical question
is, can the U.S. and global economic systems afford
to lose another major accounting firm? If not, can
the Sarbanes-Oxley Act promote the ethical
behavior necessary for survival? The relevant pro-
visions of Sarbanes are discussed in ‘‘Sarbanes-Oxley
Act of 2000 Section.
Sarbanes-Oxley Act of 2002
‘‘Today I sign the most far-reaching reforms of
American business practices since the time of Franklin
Delano Roosevelt. This new law sends very clear
messages that all concerned must heed. This law says to
every dishonest corporate leader: you will be exposed
and punished; the era of low standards and false profits
is over; no boardroom in America is above or beyond
the law.’’ (Bush, 2002).
Almost two years have passed since the signing of the
Sarbanes-Oxley Act (Sarbanes), and the scandals and
restatements continue. We are still witnessing cor-
porate misconduct and failure, as well as unethical
actions in hedge funds, the stock exchanges, and
mutual funds. Sarbanes takes a strong punitive ap-
proach to regulating public accountants, corporate
management, and investment houses calling for an
ethical tone at the top as well as an ethical corporate
culture. Sarbanes is very inclusive and prescribes ex-
pected behaviors, ethical responsibilities, and certifi-
cations that carry heavy penalties if violated. Our
discussion focuses on the provisions of Sarbanes that
have direct implications for corporate and accounting
firm ethical behavior. These provisions are outlined in
Table IV and the major points are discussed next.
Corporate ethical provisions
Sarbanes primary focus is on regulating corporate
conduct in an attempt to promote ethical behavior
and prevent the fraudulent financial reporting
42 Howard Rockness and Joanne Rockness
T A
B L E
IV
K e y
b e h av
io ra
l p ro
v is io
n s
o f
S ar
b an
e s-
O x le
y fo
r is su
e rs
an d
au d it o rs
o f
fi n an
c ia
l st
at e m
e n ts
T it le
S e c ti o n
S u b je
c t
C o n te
n t
I. P u b li c
C o m
p an
y
A c c o u n ti n g
O v e rs
ig h t
B o ar
d
1 0 5
In v e st
ig at
io n s
an d
d is c ip
li n ar
y p ro
c e e d in
g s
In v e st
ig at
io n
p ro
c e d u re
s, d is c ip
li n ar
y h e ar
in g s,
an d
sa n c ti o n s
o f
fi rm
s an
d as
so c ia
te d
p e rs
o n s
II .
A u d it o r
In d e p e n d e n c e
2 0 1
P ro
h ib
it e d
se rv
ic e s
P ro
h ib
it s
e x te
rn al
au d it o r
fr o m
e n g ag
in g
in n in
e sp
e c ifi
c
n o n -a
u d it
se rv
ic e s
fo r
th e
au d it
c li e n t
2 0 3
P ar
tn e r
ro ta
ti o n
M an
d at
e s
le ad
an d
re v ie
w in
g p ar
tn e r
ro ta
ti o n
e v e ry
fi v e
y e ar
s,
o th
e r
au d it
p ar
tn e rs
m u st
ro ta
te e v e ry
se v e n
y e ar
s
2 0 6
C o n fl ic
ts o f
in te
re st
P ro
h ib
it s
e m
p lo
y m
e n t
o f
C E
O ,
C o n tr
o ll e r,
C h ie
f A
c c o u n ti n g
O ffi
c e r
o r
e q u iv
al e n t
b y
fi rm
’s au
d it
fi rm
w it h in
o n e
y e ar
o f
e m
p lo
y m
e n t
II I.
C o rp
o ra
te R
e sp
o n si
b il it y
3 0 2
C o rp
o ra
te re
sp o n si b il it y
fo r
fi n an
c ia
l
re p o rt
s
C E
O an
d C
F O
m u st
c e rt
if y
‘‘ th
e ap
p ro
p ri
at e n e ss
o f
th e
fi n an
c ia
l st
at e m
e n ts
an d
d is c lo
su re
s’ ’
an d
th at
th e
‘‘ fi n an
c ia
l
st at
e m
e n ts
an d
d is c lo
su re
s fa
ir ly
p re
se n t
(. ..
) th
e o p e ra
ti o n s
an d
fi n an
c ia
l c o n d it io
n o f
th e
is su
e r.
’’
3 0 3
Im p ro
p e r
in fl u e n c e
o n
c o n d u c t
o f
au d it s
U n la
w fu
l fo
r o ffi
c e r
o r
d ir
e c to
r o f
fi rm
to ta
k e
an y
ac ti o n
to in
fl u e n c e , c o e rc
e , m
an ip
u la
te , o r
m is le
ad an
y au
d it o r
e n g ag
e d
in p e rf
o rm
in g
th e
au d it
fo r
th e
p u rp
o se
o f
re p o rt
in g
m at
e ri
al ly
m is le
ad in
g fi n an
c ia
l st
at e m
e n ts
3 0 4
F o rf
e it u re
o f
c e rt
ai n
b o n u se
s an
d p ro
fi ts
C E
O an
d C
F O
sh al
l ‘‘ re
im b u rs
e th
e is su
e r
fo r
an y
b o n u s
o r
o th
e r
in c e n ti v e -b
as e d
o r
e q u it y -b
as e d
c o m
p e n sa
ti o n
re c e iv
e d ’’
o r
‘‘ p ro
fi ts
re al
iz e d
fr o m
sa le
o f se
c u ri
ti e s
o f th
e is su
e r’
’ d u ri
n g
th e
tw e lv
e m
o n th
s fo
ll o w
in g
th e
is su
e o r
fi li n g
o f
st at
e m
e n ts
re q u ir
in g
la te
r re
st at
e m
e n t
3 0 5
O ffi
c e r
an d
d ir
e c to
r b ar
s an
d p e n al
ti e s
S E
C m
ay p ro
h ib
it an
y p e rs
o n
v io
la ti n g
se c ti o n
1 0 b
o f
1 9 3 4
A c t
fr o m
ac ti n g
as o ffi
c e r
o r
d ir
e c to
r o f
an y
is su
e r
if
p e rs
o n
e n g ag
e s
in c o n d u c t
w h ic
h ‘‘ d e m
o n st
ra te
s u n fi tn
e ss
’’
to se
rv e
3 0 6
In si d e r
tr ad
e s
d u ri
n g
p e n si o n
fu n d
b la
c k o u t
d at
e s
P ro
h ib
it s
p u rc
h as
e o r
sa le
o f
st o c k
b y
o ffi
c e rs
, d ir
e c to
rs ,
o r
o th
e r
in si d e r
d u ri
n g
b la
c k
o u t
p e ri
o d s
IV .
E n h an
c e d
F in
an c ia
l
D is c lo
su re
s
4 0 2
E n h an
c e d
c o n fl ic
t o f
in te
re st
p ro
v is io
n s
In c lu
d e s
p ro
h ib
it io
n o f
p e rs
o n al
lo an
s to
d ir
e c to
rs o r
o ffi
c e rs
4 0 4
In te
rn al
c o n tr
o l
re p o rt
in g
M an
ag e m
e n t
m u st
is su
e an
an n u al
re p o rt
w it h
au d it o r
at te
st at
io n
o n
th e
e ff e c ti v e n e ss
o f
in te
rn al
c o n tr
o ls
an d
p ro
c e d u re
s fo
r fi n an
c ia
l re
p o rt
in g
Legislated Ethics: From Enron to Sarbanes-Oxley 43
T A
B L E
IV
C o n ti n u e d
T it le
S e c ti o n
S u b je
c t
C o n te
n t
4 0 6
C o d e
o f
e th
ic s
fo r
se n io
r fi n an
c ia
l o ffi
c e rs
R e q u ir
e s
is su
e r
to d is c lo
se if
it h as
ad o p te
d a
c o d e
o f
e th
ic s
fo r
it s
se n io
r fi n an
c ia
l o ffi
c e rs
an d
th e
c o n te
n t
o f
th e
c o d e
V .
A n al
y st
C o n fl ic
ts o f
In te
re st
5 0 1
T re
at m
e n t
o f
se c u ri
ty an
al y st
s b y
re g is te
re d
se c u ri
ti e s
as so
c ia
ti o n s
an d
n at
io n al
se c u ri
ty
e x c h an
g e s
R e q u ir
e s
se c u ri
ti e s
as so
c ia
ti o n s
an d
se c u ri
ti e s
e x c h an
g e s
to
ad o p t
c o n fl ic
t o f
in te
re st
ru le
s
V II
I. C
o rp
o ra
te an
d C
ri m
in al
F ra
u d
A c c o u n ta
b il it
y
8 0 2
C ri
m in
al p e n al
ti e s
fo r
al te
ri n g
d o c u m
e n ts
F e lo
n y
to k n o w
in g ly
d e st
ro y
d o c u m
e n ts
to ‘‘ im
p e d e ,
o b st
ru c t
o r
in fl u e n c e ’’
e x is ti n g
o r
c o n te
m p la
te d
fe d e ra
l in
v e st
ig at
io n .
R e q u ir
e s
re te
n ti o n
o f
au d it
p ap
e rs
fo r
fi v e
y e ar
s. E
x te
n d s
st at
u te
o f li m
it at
io n s
to fi v e
y e ar
s fr
o m
fr au
d o r
tw o
y e ar
s fr
o m
d is c o v e ry
8 0 6
P ro
te c ti o n
fo r
e m
p lo
y e e s
o f
p u b li c ly
tr ad
e d
c o m
p an
ie s
w h o
p ro
v id
e e v id
e n c e
o f
fr au
d
‘‘ W
h is tl e b lo
w e r
p ro
te c ti o n ’’
fo r
e m
p lo
y e e s
o f
is su
e rs
an d
ac c o u n ti n g
fi rm
s w
h o
d is c lo
se e m
p lo
y e r
in fo
rm at
io n
to p ar
ti e s
in a
ju d ic
ia l
p ro
c e e d in
g in
v o lv
in g
fr au
d c la
im
8 0 7
C ri
m in
al p e n al
ti e s
fo r
d e fr
au d in
g
sh ar
e h o ld
e rs
o f
p u b li c ly
tr ad
e d
c o m
p an
ie s
N e w
c ri
m e
fo r
se c u ri
ti e s
fr au
d w
it h
fi n e s
an d
u p
to 1 0
y e ar
s
im p ri
so n m
e n t
IX .
W h it e
C o ll ar
C ri
m e
P e n al
ty 9 0 3
C ri
m in
al p e n al
ti e s
fo r
m ai
l an
d w
ir e
fr au
d P e n al
ty in
c re
as e d
fr o m
5 y e ar
s to
1 0
y e ar
s
9 0 6
C o rp
o ra
te re
sp o n si b il it y
fo r
fi n an
c ia
l re
p o rt
s P e n al
ti e s
fo r
w il lf u ll y
an d
k n o w
in g ly
fi li n g
fr au
d u le
n t
fi n an
c ia
l
re p o rt
s in
c lu
d e
fi n e
u p
to $ 5 ,0
0 0 ,0
0 0
an d / o r
u p
to 2 0
y e ar
s in
p ri
so n
X I.
C o rp
o ra
te F ra
u d
an d
A c c o u n ta
b il it
y
1 1 0 2
T am
p e ri
n g
w it h
a re
c o rd
o r
o th
e rw
is e
im p e d in
g an
o ffi
c ia
l p ro
c e e d in
g
E st
ab li sh
e s
c ri
m in
al p e n al
ty o f
u p
to 2 0
y e ar
s an
d fi n e
fo r
d e st
ro y in
g o r
ta m
p e ri
n g
w it h
d o c u m
e n ts
w it h
in te
n t
to im
p ai
r
u se
in o ffi
c ia
l p ro
c e e d in
g o r
o th
e rw
is e
im p e d e
o ffi
c ia
l
p ro
c e e d in
g
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44 Howard Rockness and Joanne Rockness
failures of the past decade. The legislation applies to
the Board of Directors, the Audit Committee, the
CEO, the CFO, and all other management per-
sonnel that have influence over the accuracy and
adequacy of external financial reports.
Section 301 addresses the responsibilities of the
Board of Directors’ Audit Committee. Corporate
audit committee responsibilities have increased sig-
nificantly. In some of the recent ethical failures, the
audit committee was directly involved, perceived as
too closely tied to the corporation, or oblivious to
financial reporting situations (Lublin and Carms,
2003). Under Sarbanes, audit committees are di-
rectly responsible for appointment and compensa-
tion of the external auditor and must approve all
non-audit services provided by the external auditor.
Audit committee members must also be independent
which means they may not receive fees from the
company other than for board service and may not
be affiliated in other ways. The audit committee
must provide a mechanism for direct communica-
tion of unethical behavior within the organization
by employees and the external auditor and must
establish appropriate procedures to facilitate this
communication.
Additionally Sarbanes requires all audit commit-
tees to have a financial expert on the committee or
disclose why they do not have such an expert. One
of the concerns was the ability of audit committees
to understand fully the financial reporting issues and
recognize unethical or fraudulent behavior. Thus, at
least one member of the committee must have sig-
nificant financial training and knowledge.
Much of the legislation is aimed directly at senior
management. Section 302 is probably the most sig-
nificant provision for CEO’s and CFO’s requiring
certification of the financial statements. Both the
CEO and CFO must sign and certify personally that
the company’s financial report does not contain any
known untrue material statement(s) or omit a
material fact(s). In addition, they must attest that
they are responsible for establishing and maintaining
internal controls, that disclosure is made of any
changes in internal controls and they have evaluated
the effectiveness of the internal controls within
90 days prior to the report. Certifications of financial
statements were required beginning in August 2002
with management reporting on the effectiveness of
internal controls extended to year ends after
November 20, 2004 for large companies (SEC,
2003b).
The consequences of failing to certify statements
or signing false statements are severe. CEO’s and
CFO’s are subject to a 5 million dollar fine and a 20-
year prison term. Violation of the certification reg-
ulation falls under federal court jurisdiction without
option for parole. As discussed earlier, HealthSouth’s
former CEO, Scrushy, was the object of the first
major indictment under this legislation (National
Accounting News, 2003).
Sarbanes provisions 303, 304, and 306 further
promote ethical conduct by the board of directors,
corporate executives and key employees. It is
unlawful for an officer or director to take any action
to influence or mislead the external auditor. CEO’s
and CFO’s must forfeit bonuses and profits when
earnings are restated due to fraud. Executives are
prohibited from selling stock during blackout peri-
ods and are prevented from receiving company loans
unavailable to outsiders. These provisions directly
reflect the unethical and fraudulent activities wit-
nessed at Enron that precipitated the legislation.
Sarbanes takes a much stronger consequences
(jail-time) approach to legislating ethical behavior
than the U.S. has experienced in past regulation.
Key provisions of the Act: raised the maximum
penalty for securities fraud to 25 years, raised max-
imum penalties for mail and wire fraud to 20 years,
created a 20 year crime for destroying, altering or
fabricating records in federal investigations, and re-
quired preservation of key financial audit documents
and e-mail for five years with a 10-year penalty for
destroying such documents. As with CEO/CFO
certification, these criminal charges fall under federal
jurisdiction. Under the Sentencing Reform Act of
1984, parole for federal offenders was abolished
(Murphy, 2002). In response to requirements of
Sarbanes, the Federal Sentencing Commission pro-
mulgated emergency guidelines in November 2003
to ensure that corporate criminal sentences are suf-
ficiently severe to ‘‘deter, prevent and punish such
offenses’’ including longer sentences for larger dollar
losses (Robinson and Lashway, 2003). Robinson and
Lashway provide an example under the new
guidelines: ‘‘assume the CFO of a Fortune 500
company is convicted after trial of participating in a
complex accounting fraud that causes $150 million
in losses. Further assume the CFO directed six
Legislated Ethics: From Enron to Sarbanes-Oxley 45
members of the accounting staff in carrying out the
fraud’’. The CFO now faces a sentencing range of at
least 30 years to life with no possibility of parole,
even if it is a first offense (Robinson and Lashway,
2003). The guidelines also require that anyone
convicted of obstruction of justice serve a mandatory
prison sentence.
Sarbanes not only legislates strong punishment for
wrongdoers but also prescribes guidelines for cor-
porations to establish an ethical culture in order to
maintain a high level of integrity. The tone at the
top is cited as key to an ethical corporate culture.
Section 406 requires public corporations to have a
code of ethics for senior executives or to state in
their annual report that they do not have such a code
as well as why they do not. The code must be
available to the public. Under SEC rules, detailed
guidance for the content of the code is provided
including: promotion of honest and ethical conduct,
full and fair disclosure, compliance with laws,
internal reporting for violations, and accountability
for adherence to the code (SEC, 2003b). Whistle-
blowers are protected under Section 1107, and
individuals who retaliate against whistleblowers are
personally liable and face penalties up to 10 years.
Accounting firm ethical provisions of Sarbanes
Sarbanes has changed the basic structure of the U.S.
public accounting profession. The first section cre-
ates the Public Company Accounting Oversight
Board (PCAOB) imposing external independent
regulation on the profession and ends self-regulation
under the AICPA. The Act applies to all CPA’s
serving U.S. publicly traded clients. A majority of
members of the five-member PCAOB board are not
and can never have been CPAs. This Board now sets
auditing standards and conducts inspections of CPA
firms. The Board also is responsible for disciplinary
actions against CPAs and for setting the ethical tone
for the profession. A recent quote from the Board
Chairman William McDonough makes their ethical
expectations clear to the profession: ‘‘I expect that
you, as members of a regulated profession, know
what the rules are. I expect that you are following
those rules, both in their letter and their spirit. If you
depart from those expectations – that is, if you break
the rules, if you ignore the spirit of the law even
while meeting the letter – woe be unto you. There
will be consequences, and they will be grave’’
(McDonough, 2003).
Section 201 of the Act is a direct response to the
conflict of interest issues arising from the consulting
and external audit services provided to Enron by
Andersen. This section has a very significant impact
on the CPA profession. Most other professional
services auditors historically performed for their
audit clients (Table V lists the restricted services) are
prohibited. Board of directors approval is required
for any services provided by the external auditor in
addition to the external audit that are not specifically
prohibited by Sarbanes. Evidence to date indicates
that corporate boards are reluctant to approve even
permissible tax services by their external auditors.
Sam DiPiazza, CEO PricewaterhouseCoopers, tes-
tified that PWC had lost 20% of its U.S. tax work
since the passage of Sarbanes (DiPiazza, 2003). The
prohibited services mirror the SEC proposal of 2000
with one significant addition: the PCAOB now has
the authority to determine any other impermissible
services. This gives the PCAOB complete control to
regulate the independence and thereby conflicts of
interest in the attest function.
To further strengthen independence, Section 203
mandates audit partner rotation. The lead auditor
must rotate off an audit every five years with a five-
year time out. Other audit partners must rotate after
seven years with a two-year time out. The intent is
to keep auditors from getting too close to their cli-
ents and to inhibit unethical or fraudulent collusion
between auditors and clients. Prior to the Act, sug-
gestions were made for mandatory audit firm rota-
TABLE V
Prohibited services by External Auditors for Audit
Clients under Sarbanes-Oxley Act
Bookkeeping
Financial information systems design and implementation
Appraisal or valuation services, fairness opinions
Actuarial services
Internal audit outsourcing services
Management functions or human resources
Broker or dealer, investment adviser or investment
banking services
Legal services and expert services
Any other service the PCAOB determines impermissible
46 Howard Rockness and Joanne Rockness
tion and Sarbanes required a study to further
examine the feasibility of rotation of audit firms. The
GAO concluded in November 2003 that mandatory
firm rotation was not the most efficient way to
strengthen auditor independence or improve audit
quality considering additional costs and institutional
knowledge (GAO, 2003).
The final conflict of interest issue addressed by
Section 206 is the well-known practice of corpora-
tions hiring their external auditor’s staff as financial
managers, controllers and CFO’s. It has been a long
standing and common practice for auditors leaving
public accounting to accept employment with an
audit client. This was especially true at HealthSouth.
Section 206 now prohibits such employment within
a one-year period of the audit. SEC regulations are
more restrictive. They prohibit employment in a
management position overseeing financial reporting
matters of the lead partner, the concurring partner,
or any other member of the audit engagement team
who provided more than ten hours of audit, review,
or attest services within the one-year period pre-
ceding the start of the audit (SEC, 2003a).
Basic premises for ethical financial reporting
‘‘We have learned the same thing again and again:
financial fraud does not start with dishonesty, your
boss doesn’t come to you and say, ‘Let’s do some
financial fraud’. Fraud occurs because the culture has
become infected. It spreads like an unstoppable virus.’’
(Young, 2003)
The preceding description and analysis of fraudulent
financial reporting as well as regulatory responses
suggests four premises.
Premise 1: History suggests that legislative attempts to
impose ethical behavior in corporate financial man-
agement and reporting have failed.
As demonstrated in this paper, the almost one hundred
year history of U.S. legislation attempting to impose
transparency, integrity, and honesty as underlying
values in corporate management and financial
reporting has failed to prevent periodic systemic eth-
ical failure. They often have proven effective for a
time. However, management and their external
auditors have responded to legislated behaviors by
finding new ways to obscure results; defraud share-
holders, customers, or suppliers; and hide failure. In
the latest wave of corporate fraudulent reporting, the
SEC history of fines for offending corporations and
civil proceedings against senior management evi-
dently were not effective deterrents. Occasional U.S.
Department of Justice criminal proceedings resulting
in light sentences in federal white-collar crime prisons
also were not effective deterrents.
Premise 2: Corporate controls in an IT world cannot
and will not prevent corporate fraud.
There is a tendency to believe that the advent of
large, complex, sophisticated electronic information
systems for financial reporting and operations can
limit the potential for wide-spread unethical
behavior in financial reporting. The financial
reporting frauds, errors, and restatements including
those identified in this paper raise serious doubts
about the progress companies have made in using IT
to improve the accuracy, reliability, and integrity of
financial data and financial reporting. The failures
chronicled in this paper can be traced to three IT
weaknesses: internal control systems are built on a set
of assumptions that have proven invalid; internal
controls are difficult to design, implement, and
document in today’s complex business environment;
and internal audit has assumed a much less significant
role in many corporations at a time that systems have
become more difficult to audit.
Assumptions underlying IT controls do not reflect
the business environment existing in the previously
discussed corporate failures. IT controls are designed
to ensure the integrity of data assuming the data
reflect actual transactions, are correctly captured, and
are appropriately classified. Controls are designed
into the systems to limit the potential for inappro-
priate access, guarantee the numerical integrity of
data transmitted and processed, and prevent unau-
thorized modification of software, data or reports.
The underlying assumption in control design is that
fraud will be deterred by (Carmichael, 1970) 1
� Threat of exposure; � Independent individuals reporting irregularities; � A low probability of collusion because asking is
too risky;
Legislated Ethics: From Enron to Sarbanes-Oxley 47
� Records and documentation providing proof of actions and transactions;
� A lack of inherent conflict between performance goals and the production of reliable information;
� Senior management that will not override the system.
Simons (1999) argues that these behavioral assump-
tions still form the foundation for most internal
control systems. The unethical and fraudulent
behavior at WorldCom, Enron, HealthSouth, and
Andersen as well as the other frauds in Table II
question the veracity of IT assumptions. Senior
management involvement, collusion, fraudulent
documentation, and lack of individual reporting
were evident in most cases. Thus IT controls based
on these assumptions did not prevent failures and
there is no reason to expect them to prevent future
failures.
The complexities of today’s business environ-
ments make high quality IT controls much more
difficult to design, implement, and maintain. The
average $1 billion company has 48 different financial
systems and uses 2.7 different ERP systems. (Hackett
Group, 2004). Typically, these systems do not
communicate electronically. Rather, companies still
make wide spread use of hand consolidation of dis-
parate systems on electronic spreadsheets making
entries difficult to document, control, and audit.
Furthermore, the growth of off-balance sheet
transactions has removed many transactions from the
domain of the formal information systems. IT con-
trol systems are further complicated with attempted
integration of financial reporting systems and tax
systems.
In our current state, the IT controls may provide
more opportunity for unethical and fraudulent
behavior than they prevent and create the oppor-
tunity to make the fraud bigger through mechani-
zation. For example, HealthSouth employees were
able to enter a large number of small transactions for
assets at a large number of widely disbursed facilities
with each transaction small enough to be under the
external auditor’s dollar threshold for the asset. The
magnitude of this fraud ($800 million) would have
been difficult without IT (SEC, 2003c).
Finally, there has been less emphasis on the
internal audit function. In the 1990s many corpo-
rations shrunk or disbanded internal audit groups
and outsourced all or part of the internal audit
function to their external auditors or other consul-
tants. Even those who did not outsource internal
audit and/or development of internal control sys-
tems struggled with the maintenance of internal
control across business units and across geographic
regions. The shrinking role of internal audit, less
attention paid to internal controls, and the difficul-
ties of auditing complex, disparate systems came at a
time when the incentives for management to engage
in fraudulent financial reporting had never been
higher given the heavy reliance by corporations on
performance-based pay at multiple layers in the
organization.
Premise 3: A strong corporate culture as the context
and imbedded corporate ethical values as the driver of
behavior are a necessary condition for ‘‘fixing’’
financial management and reporting.
‘‘A corporation’s culture is what determines how
people behave when they are not being watched.’’
(Tierney, 2002)
Solomon (1992) reminds us that business ethics is
not a set of impositions and constraints but rather is
the motivating force behind business behaviors and
that virtues are social traits even though they are
reflected in individual actions. In the business con-
text, the set of social traits form a key component of
the corporate culture. Schein (1999) describes cor-
porate culture as the ‘‘sum total of all the shared,
taken-for-granted assumptions that a group has
learned throughout its history’’ from mission and
goals to deep underlying assumptions about the
nature of truth, human nature, and human rela-
tionships. Kotter and Heskett (1992) emphasize that
corporate culture should be built on ‘‘doing the right
thing’’ on behalf of corporate constituencies
including customers, employees, suppliers, and
stockholders. Common to all is the need for the
organization’s leadership to nurture culture in ways
that imbed virtue in the set of assumptions under-
lying the culture. Schein (1992) suggests that cor-
porate leaders communicate the organizations values
and ethics (and thereby the assumptions underlying
the culture) by the focus of their attention and also
by what they ignore.
Morris (2002) provides a discussion of three
corporate trends that emerged with regard to the
ethical behavior of both corporate leaders and their
48 Howard Rockness and Joanne Rockness
auditors that provide some insight into how uneth-
ical behavior has grown in the face of corporate
codes of ethics and external penalties for fraud. First,
there has been a growing attitude that ethics is just a
matter of having rules and playing by the rules. It
became a game to see who could most creatively stay
within the letter of the law while bending the rules
for personal gain. The acceptable practice was to do
what was technically correct regardless of the moral
correctness of the action. Second, people were more
concerned about externals than internal matters. The
drive for personal happiness became focused on
external wealth and success rather than internal sat-
isfaction. And third, the panic for quick results re-
placed patience and more modest expectations.
Kotter and Heskett (1992) emphasizes that cor-
porate culture should be built ‘‘doing the right
thing’’ on behalf of corporate constituencies. Turner
(2002) argues that ‘‘. . .we need a cultural change’’. The excesses of the 1990s have led to too many
businesses, playing too close to the line. And, often
the line has been crossed. Waters and Bird (1987)
conclude that it is easier to influence ethical behavior
through culture than through bureaucratic rules.
Dobson (1990), arguing from a global perspective,
suggests that when there are managers and employ-
ees that do not have the desired ethical attitude, the
result is a weak set of beliefs and a non-ethical cul-
ture. He further argues that the resulting changes
will result from economic needs rather than ethical
ones. Thus, failure to build a strong culture, or
building a culture that tolerates inappropriate
behaviors, allows the inappropriate behaviors to
spread across the organization in ways that makes
significant fraud not only possible but likely (Levitt,
1998). The failures at Enron, Worldcom, Tyco,
Healthsouth, and many of the others reflect uneth-
ical values at the very top of organization accom-
panied by a culture accepting of unethical behavior.
The results are well-chronicled here and elsewhere.
It is important to recognize the stark difference
between a strong culture (usually characterized by a
strong leader as in our examples) and a strong ethical
culture. Kotter and Heskett (1992) conclude that
there is a positive relationship between strong cul-
ture and economic performance but it is modest.
Furthermore, ‘‘with much success, that strong cul-
ture can easily become arrogant, inwardly focused,
and bureaucratic.’’ (Kotter and Heskett, 1992,
p. 24). The long-run successful corporation is
characterized by norms and values that reflect caring
deeply about their customers, employees, and
stockholders, a deep commitment to leadership and
other engines that can help firms adapt to a changing
environment. At the same time, the culture must be
intolerant of arrogance in others and in themselves
(Kotter and Heskett, 1992). The firms we have re-
viewed reflect strong cultures exhibiting great suc-
cess for a time, arrogance, and an inability to deal
with changing economic circumstances in a positive,
ethical, constructive manner. They reflected a strong
but unethical tone at the top which reached through
the organization. The end result was failure.
We have documented a variety of settings in
which the very people who might be expected to
establish a strong culture with strong ethical values
reaching across the organization have been at best
contributors and more frequently instigators of
unethical or fraudulent behavior. Similarly, the
Treadway Commission (1987) found that a signifi-
cant portion of companies committing financial
reporting fraud had founders and Board members
who retained significant ownership. COSO (1999)
found that 72 of the 200 fraud cases they examined
appeared to involve the CEO and the companies’
Boards were dominated by insiders. Thus, a strong
culture is not the same as a strong ethical culture.
Repeatedly, strong cultures emerged in the 1990s
(Enron, WorldCom, Health South) that were not
built on doing the right thing so much as achieving
the ‘‘right outcome.’’ These cultures proved unable
to support appropriate ethical behaviors when these
organizations encountered difficult times. As we
move forward, it is our conclusion that the
responsibility for ensuring an ethical culture must
rest not only with the CEO but also with an inde-
pendent Board of Directors. The Board must be
responsible for the values and ethics they seek in
officers of the corporation to ensure a culture that
supports, nurtures, fosters, and attracts individuals of
high personal integrity. The Board must provide the
oversight necessary to ensure that ethical behavior is
noticed and rewarded. Similarly, the culture must
encourage the departure of those who violate the
ethical principles regardless of their other contribu-
tions to the organization.
The Board of Directors must also assume in-
creased responsibility for the control environment.
Legislated Ethics: From Enron to Sarbanes-Oxley 49
Virtually all frameworks posited for establishing and
maintaining the integrity of financial reporting begin
with the control environment (see COSO, 1992;
COBIT, 2000; for examples). COSO (1992) iden-
tifies key indicators of the control environment
including integrity, ethical values, Board of Direc-
tors participation, management philosophy, and
human resource policies and practices. The indica-
tors of significant deficiencies include insufficient
oversight by senior management, a passive audit
committee, no code of conduct or one that does not
address conflicts of interest, related party transac-
tions, illegal acts by the management and the Board,
an ineffective whistleblower program, and an inad-
equate process for responding to allegations or sus-
picions of fraud. The financial frauds identified in
Table II reflect some or all of the deficiencies
identified in the COSO(Committee of Sponsoring
Organizations of the Treadway Commission)
framework and few of the key indicators of a good
control environment.
Premise 4: Compliance with laws, internal controls,
and corporate cultural norms must be built on both
predictable rewards for ‘right’ behaviors as well as swift
delivery of significant sanctions for inappropriate
behaviors supported by strong societal sanctions.
‘‘No one should be entrusted to lead any business or
institution unless he or she has impeccable personal
integrity. Top rung executives have to ensure that the
organizations they lead are committed to a strict code
of conduct. This is not merely good corporate hy-
giene. It requires management discipline and putting
in place checks and balances to ensure compliance.’’
(Gerstner, 2002)
Solomon (1994) argues that the free market ‘‘re-
quires protection from rule breakers, those who
would take advantage of its freedoms and commit
fraud or extortion.’’ He argues, further, that such
rules and sanctions are necessary for the protection of
markets. In the 1990s, civil and criminal penalties for
fraudulent financial reporting resulting from the
Securities Acts of 1933 and 1934 proved to be
ineffective deterrents. Arguably, the societal penal-
ties for fraudulent financial reporting under the 1933
and 1934 Securities Acts were not severe enough to
deter fraudulent behavior in the 1990s. Health-
South’s Mr. Scrushy is charged with telling
employees in 1997 that earnings had to meet market
expectations until he could sell his stock. He sub-
sequently sold 7,782,130 shares of HealthSouth
stock (SEC, 2003c). Potential personal sanctions
were irrelevant in determining behavior at Health-
South. Under the 1933 and 1934 Acts, the most
likely outcome was a fine, a prohibition from serving
as an officer or director of an SEC company, and,
occasionally, a light sentence in a ‘‘white collar’’ jail.
Just as clearly, Scrushy either believed he would not
be caught or the potential penalty was insufficient to
deter the action.
Corporate codes of conduct have been suggested
or required for corporations since the Foreign
Corrupt Practices Act of 1977. They also have
proven to be a limited deterrent to unethical
behavior. Whistleblower programs, with access to
the Board of Directors for corporate wrongdoing,
were recommended by the Treadway Commission
as early as 1987, yet few whistleblowers have come
forward. Unethical behavior has continued with the
magnitude and number of frauds growing through-
out the 1990s (KPMG, 2003).
Despite codes of conduct and penalties, greed,
personal gain, and pursuit of power prevailed in
many of the cases of the 1990s. The financial frauds
corresponded to an exponential growth in executive
compensation. The Institute for Policy Studies 2003
CEO Compensation Survey compares CEO com-
pensation in the late 1990s and early 2000s with
compensation in the early 1980s. Results indicate a
dramatic increase in absolute and relative CEO
compensation during the period. They report that
average CEO pay was 42 times average production-
worker pay in 1982 but had grown to 530 times
average production-worker pay by 2000. Further,
stock options or other performance-based pay had
grown to 80 percent of CEO compensation
(Anderson et al., 2003). Our premise is that legisla-
tion, controls, and cultural norms did not deter
corporate unethical behavior by some because of the
potential for enormous personal gain. In too many
cases, senior management’s greed overcame personal
integrity and was unchecked by adequate penalties
for unethical/illegal behavior. CEO’s and CFO’s,
and in more limited cases corporate boards, did not
have the personal integrity and companies did not
have the ethical cultures in place to overcome the
potential for personal gain in light of very limited
50 Howard Rockness and Joanne Rockness
potential external sanctions. Or, simply stated, for
many CEO’s the expected benefits from stock op-
tions, position, and power were greater than the
expected cost of civil or criminal penalties if caught
and if punished.
When otherwise good people do bad things in a
financial reporting context, a more utilitarian ap-
proach may well be the way to control behavior (if
not, values). Where management is driven by ego or
greed, deterrence must be focused on outcomes. . . making the cost of unethical behavior exceed the
potential gain from the behavior. Petrick and
Scherer (2003) make a similar argument for an
interdependent moral and legal framework in their
discussion of Enron. There are three required
components. First, corporate cultures and codes of
ethics must deliver swift and meaningful sanctions
for unethical behavior including separation from the
organization. Second, internal controls including
effective whistleblower programs must make the
probability of discovering unethical behavior high.
Third, external penalties for unethical or illegal
behavior must be greater than the rewards realized
from engaging in the behavior.
Three changes in U.S. laws for societal penalties
have come together to potentially make the pun-
ishment exceed the payoff from fraudulent report-
ing. First, Sarbanes increases the penalties for
fraudulent reporting including management certifi-
cation of results and internal controls to a maximum
of $25 million and 20 years, and imposes new sen-
tencing penalties for other fraudulent actions
(Table IV). Second, revised federal sentencing
guidelines issued in 2001 substantially increase pen-
alties for economic crimes, doubling penalties for
crimes involving multi-million dollar losses. The
effect is to remove judicial discretion in imposing
sentences for white collar crimes. Sentencing
guidelines were further strengthened in 2003 at the
direction of the Sarbanes-Oxley Act (Robinson and
Lashway, 2003). Third, 1984 legislation eliminated
parole in the federal justice system (U.S. Department
of Justice, 1997). The maximum reduction in sen-
tence for good behavior is 15 percent of the sen-
tence. For example, in March of 2004, a former
senior director of tax planning at Dynegy Corpora-
tion was convicted of wire fraud, securities fraud,
conspiracy, and mail fraud. He was sentenced to
24 years and four months of which he must serve a
minimum of 20 years and 10 months. His crime –
illegally disguising corporate debt in 2001 which the
prosecution alleged caused $500 million in Dynegy
stock losses. The judge in the case said, ‘‘I take no
pleasure in sentencing you to 292 months. Some-
times good people commit bad acts, and that’s what
happened in this case’’ (ABC News, 2004).
Having argued the necessity of appropriate
sanctions for fraudulent behavior, Solomon (1994)
suggests that laws, regulations, and associated pen-
alties can only help prevent behaviors already viewed
as inappropriate by those subject to the laws and
regulations. Thus, they compliment an ethical cul-
ture rather than replace the need for carefully nur-
turing a cultural built on ‘‘doing the right thing.’’
Conclusion
This paper has documented the failures of laws,
corporate internal controls, and corporate culture to
deter unethical and fraudulent financial reporting.
None, taken alone, have stood the test of time in
guaranteeing appropriate corporate ethical behavior.
Sarbanes broadens and deepens sanctions and pen-
alties for unethical management behavior but does
not address the relationship between management
behavior and rewards. Sarbanes also calls for much
greater focus on internal controls by senior man-
agement. Internal control systems, including IT
controls, can help reduce the opportunity for
fraudulent or unethical behavior but cannot elimi-
nate it in a world where nearly 50 percent of large
corporations still use spreadsheets in some aspect of
financial reporting (Hackett Group, 2004). Finally,
corporate ethical failures arguably appear more likely
to occur in very successful companies lacking a solid
ethical foundation when economic conditions
change as witnessed by our case studies and the work
of Kotter and Heskett (1992). It is the combination
of a strong ethical corporate culture (beginning with
the Board of Directors), controls, laws, rewards, and
penalties that provide a context for obtaining ethical
and transparent financial reporting.
We believe research exploring the interactions
between and among corporate culture, internal
controls, societal controls, and rewards/sanctions
will provide better answers than we now have for
improving corporate financial reporting.
Legislated Ethics: From Enron to Sarbanes-Oxley 51
Note
1 Douglas Carmichael is now the Chief Auditor and
Director of Financial Standards of the PCAOB (PCAOB,
2003).
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Howard Rockness
Professor of Accounting,
University of North Carolina – Wilmington,
601 S. College Road,
Wilmington,
NC 20493,
U.S.A.
E-mail: [email protected]
Joanne Rockness
Cameron Professor of Accounting,
University of North Carolina – Wilmington,
601 S. College Road,
Wilmington,
NC 20493,
U.S.A.
E-mail: [email protected]
54 Howard Rockness and Joanne Rockness
