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Assessment of Tone at the Top

A C C O U N T I N G & A U D I T I N G a u d i t i n g

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By Susan S. Lightle, Bud Baker, and Joseph F. Castellano

The Psychology of Control Risk Assessment

Standards require that auditors assess an entity’s internal controls over financial reporting (ICFR), includ- ing the control environment, which is influenced by the tone set by management and the board regarding the importance of ICFR and the expected standards of employee conduct. This article argues that auditors cannot assess the tone at the top by simply checking off a list of control mechanisms; they must understand what motivates behavior within the organization (what might be called the psychology of control risk assess- ment). It also illustrates a model to help auditors anticipate when an organization is prone to earnings manipulation, and suggests how to assess the tone at the top of an organization.

In Brief

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I n the late 1960s and early 1970s, the U.S.-based energy conglomerate ITT put together a remarkable string of earnings increases under the leadership

of Harold Geneen: ITT increased its net earnings each and every quarter, for 58 consecutive quarters, or more than 14 years of Geneen’s 18-year tenure. Geneen was lionized for this achievement; he became the highest paid executive in the United States, authored best-selling books, and was memorialized across the country in the form of new centers, buildings, and foun- dations (Harvey D. Shapiro, “Management Was the Message,” New York Times, March 10, 1985, http://www.nytimes. com/1985/03/10/books/management-was- the-message.html). Only in retrospect, after Geneen’s departure and the subsequent dis- mantling of most of ITT, did it become clear that those 58 straight quarters of growth were not what they seemed to be.

The Price of Success Earnings management—a benign

euphemism for financial manipulation— is not a wholly irrational activity, albeit an unethical one. In addition to the praise heaped upon high flyers like ITT under Geneen, researchers have demonstrated that companies reporting 20 consecutive quar- ters of earnings increases enjoy greater profitability, higher stock valuations, and higher price-earnings ratios than counter- parts with similar underlying financial strength (James N. Myers, Linda A. Myers, Douglas J. Skinner, “Earnings Momentum and Earnings Management,” August 2006, http://ssrn.com/abstract=741244 or http://dx.doi.org/10.2139/ssrn.741244).

But Myers, et al., also showed that this “success” comes with a price: All those previously positive measures decline markedly when the unbroken sequence of quarterly successes finally ends; the longer the quarterly streak of good news runs, the deeper the firm’s plunge when the time of reckoning arrives. Efforts to manipu- late earnings are practiced by widely dis- parate companies and CEOs, whether lit- tle known or famous; publicly regarded as miscreants or successful individuals; American, multinational, or foreign (Sheila Keefe, “A $1.7 Billion Fraud Born of Earnings Management and a Poor Ethical Culture,” ACFE Insights, Feb. 6, 2012,

h t t p : / / w w w . a c f e i n s i g h t s . c o m / acfe-insights/2012/2/6/a-17-billion-fraud- born-of-earnings-management-and-a-poor- et.html).

How Internal Controls Fail Recognizing the undesirable effects of

earnings manipulation, legislators and researchers have turned their attention to the integrity of the financial reporting system. The Sarbanes-Oxley Act of 2002 (SOX) increased penalties for financial misreporting and raised auditors’ respon- sibility for internal controls over financial reporting (ICFR). Still, surveys and inter- views of chief financial officers reveal that CFOs believe that 20% of companies prac- tice some form of earnings management (Ilia D. Dichev, John R. Graham, Campbell R. Harvey, Shivaram Rajgopal, “Earnings Quality: Evidence from the Field,” May 7, 2013, http:// ssrn.com/ abstract= 2103384).

Other authors have discussed the tremen- dous pressure upon CEOs to “make their numbers” to show results for investors, analysts, and directors; failure to meet these expectations results in plunging stock prices and plummeting careers, which are espe- cially threatening to executives who occu- py les s s ecure positions (Te rry L. Campbell, Melissa B. Frye, Weishen Wang, “How Do Entrenched Managers Handle Analyst Pressure?” 2009, http:// www.fma.org/Reno/Papers/ Analyst Pressure CampbellFryeWang.pdf). In addi- tion to protecting the stock price and sat- isfying board expectations, CEOs may be motivated to commit financial reporting fraud to meet bonus and compensation tar- gets. Ego may be another factor, especial- ly in situations where the CEO was brought in to turn around a failing company.

The tone at the top of the organization can strengthen internal controls or cir- cumvent even the most sophisticated man- agement control systems. Controls designed to strengthen the control envi- ronment and tone at the top include an engaged board and audit committee with a zero tolerance policy regarding aggres- sive accounting manipulations, as well as compensation policies that focus on long- term, as opposed to short-term, outcomes. Other relevant controls are the implemen- tation and enforcement of an effective code of ethics and a whistleblower policy that

encourages internal reporting of question- able accounting practices. While it is man- agement’s responsibility to design and implement ICFR, ultimately the board oversight is the most effective way to assure that such controls are in place.

This article focuses on the external audi- tor’s assessment of the risk of fraudulent financial reporting. Fraud risk assessment includes consideration of the “fraud trian- gle” (i.e., the motivation, opportunity, and rationalization or attitude that are typical- ly present when fraud is committed). The motivation to commit financial reporting fraud is well understood. Controls designed to limit the opportunity to commit report- ing fraud are well defined in the auditing literature. There is less guidance avail- able, however, with respect to the assess- ment of the attitude of management toward earnings manipulation. A model bor- rowed from the organizational behavior lit- erature can help address this question.

How does an auditor assess tone? What are the signs of a corrupted tone at the top of an organization, one that is so focused on earnings manipulation that all other con- trol mechanisms are rendered useless?

Assessing the Tone at the Top An auditor’s assessment of ICFR is used

to evaluate the risk that a company’s finan- cial statements are materially misstated and to determine the extent of testing necessary to attest to the fairness of the financial state- ment presentation (SAS 122, AS 12). Professional standards provide some guid- ance: For example, the Committee of Sponsoring Organizations of the Treadway Commission (COSO) framework outlines principles associated with each component of internal control, including the control envi- ronment. In accordance with these principles, the auditor must look for evidence that the organization demonstrates a commitment to integrity and ethical values (COSO, “Internal Control–Integrated Framework Executive Summary,” May 2013).

The principles of a sound control envi- ronment include a board of directors that exercises independent oversight of the devel- opment and performance of internal controls. With board oversight, management should establish structures, reporting lines, and appro- priate authorities and responsibilities in the pursuit of objectives, as well as a commit-

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ment to attract, develop, and retain compe- tent individuals in alignment with the objec- tives. Finally, the organization should hold individuals accountable for their internal con- trol responsibilities in the pursuit of objec- tives (COSO, p. 6).

Auditors’ efforts to achieve these goals may involve obtaining evidence through interviews or surveys of employees, man-

agement, and others; review of policy man- uals and established procedures; and obser- vation of operations within the organiza- tion. For example, an auditor might ask if the client has a code of conduct, and, if so, review it and the company’s policy regard- ing the dissemination and enforcement of the code—most important, however, is the attitude of respect for the controls. If the tone at the top is superficial compliance underlying an understanding that controls will not be permitted to get in the way of meeting earnings targets, then the code of conduct is worthless.

Assessment of tone at the top is also part of the auditor’s consideration of fraud in a financial statement audit. Auditing standards identify three characteristics of fraud: 1) incentive or pressure to commit fraud, 2) a perceived opportunity to do so, and 3) some rationalization of the act (AU-C sec- tion 240.A1). The risk of fraudulent finan- cial reporting increases if top management has an incentive, opportunity, and rational- ization to distort the reported financial posi- tion and results of operations. Management stock options or bonuses dependent on finan- cial targets can create enormous pressure to manipulate the financial statements (Financial Fraud Law Report, September 2013, http:// socially responsible accounting. com/index/ wp- content/uploads/2013/08/Kravitz- FFLR-Sept- 2013.pdf), and weak internal controls over

the processing of adjusting entries at year- end might create the opportunity to do so. And a tone at the top that values “making the numbers” at all cost provides a conve- nient rationalization for committing fraud. The authors suggest a model, adapted from Anne Wilson Schaef and Diane Fassel’s identifiers of “addictive” organizations, which auditors can use to assess the culture of the

underlying reporting environment, and apply their model to the phenomenon of earnings management (The Addictive Organization, Harper, 1988, p. 58). This may help audi- tors better anticipate and identify financial reporting irregularities.

Organization as Addict Schaef and Fassel define addiction as a

substance or process that takes over the addict’s life, functioning as a buffer between the addict and reality. They see the addictive organization as a closed sys- tem (i.e., it does not recognize informa- tion that cannot be processed within its existing paradigm) that exhibits many of the characteristics of an individual addict. In addition, it displays certain underlying characteristics that serve to support the addiction. The following characteristics can be applied to a destructive preoccupation with managing earnings: n Focus on the hope that things will get better in the future n A “pseudopodic” ego—superficial open- ness to new ideas, while the system actu- ally absorbs the idea, modifies it so that it can be incorporated into its existing paradigms, and then uses it to perpetuate the existing system intact n External referencing—judging success solely upon the perceptions of others n Invalidation—redefining into nonexis-

tence those ideas and experiences that do not fit into the existing paradigms n Dualism—simplifying problems into two choices, creating a false sense of stability and discouraging creative solutions.

The common thread in all of these underlying characteristics is that they allow the organization to reject information that it does not want to acknowledge, just as individual addicts ignore warning signals that their addiction is harmful, or even life threatening. By being aware of these characteristics, auditors may be better able to identify a toxic control environment.

Things will get better in the future. It is not uncommon for companies to expe- rience temporary earnings reversals in light of normal business cycles. If the corpora- tion is overly focused on meeting revenue and earnings targets to meet Wall Street’s expectations, management may be tempt- ed to use accounting ploys or management practices to smooth out or even to elimi- nate these normal downturns. In some cases, financial reporting fraud is the method of choice.

The case of HealthSouth is one of the more egregious examples of the lengths to which a company may go to meet ana- lysts’ expectations. In March 2003, the SEC charged HealthSouth and its CEO, Richard Scrushy, with accounting fraud through systematically overstating earnings by at least $1.4 billion since 1999. Independently, the Justice Department used information from the company’s executives to identify another $1.1 billion of overstated earnings (Leonard G. Weld, Peter M. Bergevin, Lorraine Magrath, “Anatomy of a Financial Fraud,” The CPA Journal, October 2004).

SEC Director of Enforcement Stephen Cutler stated in a March 2003 press release that “HealthSouth’s standard operating pro- cedure was to manipulate the company’s earnings to create the false impression that the company was meeting Wall Street’s expectations.” In a talk given to the University of Chicago’s Booth School of Business in May 2011, Weston Smith, former HealthSouth CFO, told students that fraud starts “with thoughts like, ‘This is just temporary … We can’t disappoint Wall Street … Everybody does it” (Kadesha Thomas, Chicago Booth News, http://www.chicagobooth.edu/news/ 2011-05-31-healthsouth.aspx). However,

If the tone at the top is superficial compliance

underlying an understanding that controls will not be

permitted to get in the way of meeting earnings

targets, then the code of conduct is worthless.

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this addictive characteristic may be what endangers the firm’s future.

Auditors need to be particularly cautious when a client insists that things are turn- ing around and will get better in the future, particularly with respect to temporary cut- backs and crisis-based schemes advocated by management. An auditor must careful- ly assess the motives behind such actions in light of the real economic circumstances confronting the company, industry, and economy. It is especially important to ques- tion management’s intended reversal of any previously established reserves that have the effect of increasing earnings in order to meet earnings estimates. Such scrutiny is even more crucial when executive compensation packages are directly tied to these earnings targets. The kinds of gim- mickry discussed here may indicate that management is willing to sacrifice its integrity and the long-term best interests of the company in order to please analysts and maximize bonuses.

Pseudopodic ego. The pseudopodic ego refers to the tendency of addicts to absorb and then neutralize threatening new ideas. The earnings-addicted organization will make a show of playing by the rules, while undermining them behind the scenes.

In 1993, Cynthia Cooper was hired by a company called LDDS (renamed WorldCom) to start an international audit department. Having an internal audit func- tion was not required at the time, but it was considered a best practice by most large corporations. The company’s CEO, Bernie Ebbers, initially liked the idea of an internal audit function because the first audit report included useful recommendations for improv- ing operational efficiency and effectiveness.

However, the honeymoon between Ebbers and his new internal audit director ended abruptly when she issued a report that was critical of the company’s internal controls. In her book, Cynthia Cooper describes Ebbers’ reaction to the report: “‘What are these comments you’ve put in here about internal controls?!’ he says, agitated. His face is blood red. I’ve never seen him so upset” (Extraordinary Circumstances: The Journey of a Corporate Whistleblower, Wiley, 2008, p. 114).

Several days later she was informed by a member of the executive management team that Ebbers didn’t want her to use the words “internal controls” in her audit

reports because “it aggravates him” (Cooper 115). Ebbers absorbed the idea of an internal audit function, but neutral- ized it when it became threatening.

Assessment of ICFR is the central func- tion of internal auditors. As Cooper put it, “asking an internal auditor not use the words ‘internal controls’ is like asking a physi- cian not to use the word ‘prescription’” (Cooper 115). Despite the unsupportive (sometimes openly hostile) environment in which she found herself, Cooper and her team would eventually uncover a financial reporting fraud that overstated the compa- ny’s assets by $11 billion, one of the largest frauds in U.S. history.

By creating an internal audit department and then subverting its function, Ebbers displayed an extreme example of a pseu- dopodic ego. In their assessment of tone at the top, auditors must pay particular attention to management behavior that out- wardly supports sound ICFR practices, but in reality undermines their effectiveness.

External referencing. External refer- encing is judging success only by the per- ception of others. Of course, sound man- agement practices dictate some level of concern for how the organization is per- ceived by others, including current and potential shareholders, customers, suppli- ers, regulators, and the general public. In the addicted organization, however, man- aging the perception of others (particular- ly Wall Street) becomes obsessive, driving short-term decisions that are detrimental to the long-term health of the entity.

The saga of Al Dunlap provides a case study of external referencing. At the height of his career, Dunlap was seen by many as a miracle worker, a leader who could turn around the most desperate and catastrophic situations. On the day in July 1996 that he was appointed CEO of the troubled appli- ance maker Sunbeam, the stock price soared 49%. Such was his celebrity that the mere announcement of his hiring added $500 mil- lion to Sunbeam’s market capitalization (Sunbeam Corporation, “‘Chainsaw Al,’ Greed, and Recovery,” http://danielsethics .mgt .unm.edu).

But by mid-1998, the miracle was gone. Caught up in a channel-stuffing scheme— inducing customers to take title to goods that would normally have been sold in a later period—designed to manipulate Sunbeam’s earnings, Dunlap was dismissed

by the very board that had so confidently hired him less than two years before. As more details became clear over the ensu- ing months, it was obvious that channel stuffing was just one of the earnings man- agement stratagems that Dunlap had fos- tered (SEC Litigation Release 17001, “SEC Sues Former Top Officers of Sunbeam Corporation and Arthur Andersen Auditor in Connection with Massive Financial Fraud,” May 15, 2001, http://www.sec.gov/ litigation/litreleases/lr17001.htm).

Dunlap’s obsession with the daily—even hourly—price of Sunbeam’s stock, and its relationship to short-term earnings, was well known. Nor should anyone have been astonished that he would pressure subordinates to do whatever was necessary to meet earnings targets. Dunlap’s best- selling 1996 autobiography, Mean Business, was published just as he took over as Sunbeam’s CEO. In the book, Dunlap made his views crystal clear:

When it comes to a company’s stock price and its daily fluctuations, I believe there

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is always someone accountable. If the stock price goes up, there is a reason. If the stock price goes down, there is also a reason … I pay great attention to the hourly ups and downs … The stock price drives me. (Albert J. Dunlap, Bob Andelman, Mean Business: How I Save Bad Companies and Make Good Companies Great, Times Books/ Random House, 1996, p. 256) One might argue that a leader as cele-

brated as Dunlap could have focused on running Sunbeam effectively, trusting that the stock market and analysts would rec- ognize his superior performance in the longer run. But instead, his short-term manipulations sent the company into a tail- spin from which Chapter 11 bankruptcy was the only option (SEC Litigation Release 17001).

Auditors must pay particular attention to key performance indicators that are mon- itored by financial analysts. Behavior that results in the manipulation of such indica- tors may be a sign of external referenc- ing. Even if the client justifies the account- ing treatment on the basis of a technicali- ty, auditors should view such behavior as possible evidence of external referencing.

Invalidation. Schaef and Fassel see inval- idation as the rejection of ideas and experi- ences that do not fit existing paradigms. One of the consequences of invalidation in an

organization is the increased risk of impor- tant information and knowledge being lost, or simply rejected and ignored. Invalidation was clearly in evidence in the Enron case. Clinton Free chronicles how the leadership style of CEO Jeff Skilling created a culture at Enron that was able to overcome and cir- cumvent the sophisticated management con- trol systems that were in place (Clinton Free, Norman Macintosh, and Mitchell Stein, “Management Controls: The Organizational Fraud Triangle of Leadership, Culture and Control in Enron,” Ivey Business Journal, July/August 2007). In effect, a corrupted leadership and culture, what Free calls the organizational fraud triangle, was able to invalidate an elaborate and sophisticated set of management controls.

It’s worth noting that invalidation often involves rejection of not only the dissonant message, but also of the source of that message—that is, the best way to invalidate the criticism is to denigrate the critic. From a book on Enron:

Skilling, in particular, was infamous for dividing the world into those who ‘got it’ and those who didn’t … On the rare occasions when Skilling was pressed, he would react with scorn. ‘He did not want to be crossed in any manner, shape, or form … If you asked a question he did- n’t want to answer, he would dump a ton of data on you. But he didn’t answer.

If you were brave and said you still did- n’t get it, he would turn on you. ‘Well, it’s so obvious,’ he’d say. ‘How can you not get it?’ So the analysts and investors would pretend to get it even when they didn’t. (Bethany McLean, Peter Elkind, The Smartest Guys in the Room: The Amazing Rise and Scandalous Fall of Enron, Portfolio, 2003, p. 233) The tone set by Skilling permeated the

organization. One central feature of Enron’s management control system was their risk assessment and control group (RAC). This group was responsible for approving the firm’s trading deals and assessing risk. Another key component of Enron’s con- trol system was the peer review commit- tee (PRC), designed to ensure that employ- ee actions aligned with the company’s strategic objectives. Under this system, each employee received an evaluation every six months. Those falling into the bottom 15% had two weeks to find another job at Enron or were fired, regardless of their performance (Free 4).

The culture at Enron became one of laud- ing risk taking, pressure to make trading deals regardless of risk, and when necessary, managing earnings in order to meet analysts’ expectations. Over time, members of the RAC became increasingly reluctant to turn down any trading deals for fear of receiv- ing poor evaluations in the PRC process and for fear of Skilling’s reaction (Free 8). Former employees Peter C. Fusaro and Ross M. Miller indicated that Enron’s “rank-and- yank” PRC system created “an environment where employees were afraid to express their opinions or to question unethical and potentially illegal business practices. Because the rank-and-yank system was both arbitrary and subjective, it was easily used by man- agers to reward blind loyalty and quash brewing dissent” (What Went Wrong at Enron: Everyone’s Guide to the Largest Bankruptcy in U.S. History, Wiley, 2002).

What Fusaro and Miller described is a classic example of invalidation. Auditors should take note of management policies that effectively stifle open communication and free exchange of ideas. When man- agement policies create pressure to con- form, fraudulent behavior will not be chal- lenged within the organization.

Dualism. Dualism refers to a false dichoto- my in which an addict structures a problem so as to eliminate any reasonable alternative

EXHIBIT Warning Signs of Earnings Addiction

Characteristic Warning Sign

Belief that “things Management makes decisions based on overly optimistic will get better” assumptions about future financial or operational conditions.

Pseudopodic ego Management undertakes actions that effectively subvert or circumvent existing rules, regulations, or control mechanisms.

External referencing Management uses accounting technicalities to manipulate key performance indicators in order to gain approval from outside stakeholders.

Invalidation Management implements policies that stifle information that does not conform to management’s thinking.

Dualism Management insists on an “either-or” problem definition that drives a particular accounting treatment despite questions of its appropriateness.

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(i.e., “I take this drug, or my life is not worth living”). Organizations can think the same way. In 2009, the SEC fined General Electric (GE) $50 million for a scheme in which GE took credit for sales of hundreds of locomotives in the last month of two consecutive fiscal years, even though own- ership of the train engines did not transfer until the following year. This was no trivial shift: $370 million in revenue was misstated, and the subterfuge involved more than half of GE’s fourth-quarter locomotive produc- tion: 223 engines of the 406 sold in the last quarters of 2002 and 2003.

GE had met or exceeded earnings-per- share expectations in every quarter since 1995. Allowing that string to be broken was unthinkable to the GE financial staff: In their minds, they had to either meet the numbers, or the corporation would be embarrassed and shareholders punished. The SEC charged that during 2002 and 2003, “high-level GE accounting execu- tives or other finance personnel approved accounting that did not comply with Generally Accepted Accounting Principles” in order to hit the EPS estimates” (SEC v. General Electric Co., 2009, http://www. sec.gov/litigation/complaints/2009/ comp21166.pdf).

From an auditor’s perspective, dualism may present itself as a stubborn resistance on the part of the client to rational analy- sis of a particular transaction or class of transactions. GE’s insistence on recording the sale of the locomotives is more than an accounting irregularity. It is evidence of a mindset, one in which fraud becomes seen as an acceptable alternative.

Responding to Warning Signs The presence of the warning signs

described above may indicate a high risk of fraudulent financial reporting. Auditing stan- dards dictate that the auditor must modify the planned audit procedures to address a high assessed level of fraud risk. Specifically, the auditor should do the following: n Assign and supervise personnel, taking into account the knowledge, skill, and abil- ity of the individuals to be given signifi- cant engagement responsibilities and the auditor’s assessment of the risks of mate- rial misstatement due to fraud for the engagement n Evaluate whether the selection and appli- cation of accounting policies by the enti-

ty, particularly those related to subjective measurements and complex transactions, may indicate fraudulent financial reporting resulting from management's effort to man- age earnings or a bias that may create a material misstatement n Incorporate an element of unpredictabili- ty in the nature, timing, and extent of audit procedures (AICPA, AU-C section 29).

If an auditor detects one or more of the behaviors outlined above, he should pro- ceed with a heightened level of professional skepticism with respect to information pro- vided by management and increase the reli- ability of audit procedures used.

How Auditors Can Cope The financial markets create enormous

pressure for companies to manage earn- ings. At the same time, auditors are expect- ed to be more vigilant than ever in carry- ing out their responsibility to identify misleading financial statements. Despite repeated warnings about the long-term con- sequences of managing quarterly and year-

end earnings, many businesses persist in these behaviors to the detriment of the entire financial system. The destructive ten- dencies associated with a preoccupation with earnings manipulation often mirror the model developed by Schaef and Fassel in their work with addictive organizations. The model can help identify warning signs, summarized in the Exhibit, which audi- tors can use to assess the behavior patterns of top management and the “tone at the top.” While insight is not a panacea, an awareness of the five behavioral charac- teristics discussed in this article may be a good first step in enhancing auditors’ efforts to assess the tone at the top. q

Susan S. Lightle, PhD, CPA (inactive), is a professor of accountancy, and Bud Baker, PhD, is a professor of management, both at Wright State University, Dayton, Ohio, and Joseph F. Castellano, PhD, is a pro- fessor of accountancy at the University of Dayton, Dayton, Ohio.

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