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C C O U N T I N G
U D I T I N G
Assessment of Tone at the Top
The Psychology of Control Risk Assessment
By Susan S. Lightle, Bud Baker, and Joseph F. Castellano
In Brief
Standards require that auditors assess an entity’s internal controls over financial reporting (ICFR), including 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 assessment). 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.
50
JUNE 2015 / THE CPA JOURNAL
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 foundations (Harvey D. Shapiro, “Management
Was the Message,” New York Times,
March 10, 1985, http://www.nytimes.
com/1985/03/10/books/management-wasthe-message.html). Only in retrospect, after
Geneen’s departure and the subsequent dismantling of most of ITT, did it become
clear that those 58 straight quarters of
growth were not what they seemed to be.
I
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 quarters of earnings increases enjoy greater
profitability, higher stock valuations, and
higher price-earnings ratios than counterparts 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 manipulate earnings are practiced by widely disparate companies and CEOs, whether little 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,
JUNE 2015 / THE CPA JOURNAL
http://www.acfeinsights.com/
acfe-insights/2012/2/6/a-17-billion-fraudborn-of-earnings-management-and-a-pooret.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’ responsibility for internal controls over financial
reporting (ICFR). Still, surveys and interviews of chief financial officers reveal that
CFOs believe that 20% of companies practice 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 tremendous 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 especially threatening to executives who occupy less secure positions (Terry L.
Campbell, Melissa B. Frye, Weishen
Wang, “How Do Entrenched Managers
Handle Analyst Pressure?” 2009, http://
www.fma.org/Reno/Papers/ Analyst
PressureCampbellFryeWang.pdf). In addition to protecting the stock price and satisfying board expectations, CEOs may be
motivated to commit financial reporting
fraud to meet bonus and compensation targets. Ego may be another factor, especially 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 circumvent even the most sophisticated management control systems. Controls
designed to strengthen the control environment and tone at the top include an
engaged board and audit committee with
a zero tolerance policy regarding aggressive accounting manipulations, as well as
compensation policies that focus on longterm, as opposed to short-term, outcomes.
Other relevant controls are the implementation and enforcement of an effective code
of ethics and a whistleblower policy that
encourages internal reporting of questionable accounting practices. While it is management’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 auditor’s assessment of the risk of fraudulent
financial reporting. Fraud risk assessment
includes consideration of the “fraud triangle” (i.e., the motivation, opportunity, and
rationalization or attitude that are typically present when fraud is committed). The
motivation to commit financial reporting
fraud is well understood. Controls designed
to limit the opportunity to commit reporting fraud are well defined in the auditing
literature. There is less guidance available, however, with respect to the assessment of the attitude of management toward
earnings manipulation. A model borrowed from the organizational behavior literature 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 control 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 financial statements are materially misstated and
to determine the extent of testing necessary
to attest to the fairness of the financial statement presentation (SAS 122, AS 12).
Professional standards provide some guidance: 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 environment. 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 environment include a board of directors that
exercises independent oversight of the development and performance of internal controls.
With board oversight, management should
establish structures, reporting lines, and appropriate authorities and responsibilities in the
pursuit of objectives, as well as a commit-
51
ment to attract, develop, and retain competent individuals in alignment with the objectives. Finally, the organization should hold
individuals accountable for their internal control responsibilities in the pursuit of objectives (COSO, p. 6).
Auditors’ efforts to achieve these goals
may involve obtaining evidence through
interviews or surveys of employees, man-
the processing of adjusting entries at yearend might create the opportunity to do so.
And a tone at the top that values “making
the numbers” at all cost provides a convenient 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
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.
agement, and others; review of policy manuals and established procedures; and observation of operations within the organization. For example, an auditor might ask if
the client has a code of conduct, and, if so,
review it and the company’s policy regarding 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 section 240.A1). The risk of fraudulent financial reporting increases if top management
has an incentive, opportunity, and rationalization to distort the reported financial position and results of operations. Management
stock options or bonuses dependent on financial targets can create enormous pressure to
manipulate the financial statements (Financial
Fraud Law Report, September 2013, http://
sociallyresponsibleaccounting.com/index/wpcontent/uploads/2013/08/Kravitz-FFLR-Sept2013.pdf), and weak internal controls over
52
underlying reporting environment, and apply
their model to the phenomenon of earnings
management (The Addictive Organization,
Harper, 1988, p. 58). This may help auditors 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 system (i.e., it does not recognize information 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 openness to new ideas, while the system actually 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 experience temporary earnings reversals in light
of normal business cycles. If the corporation is overly focused on meeting revenue
and earnings targets to meet Wall Street’s
expectations, management may be tempted to use accounting ploys or management
practices to smooth out or even to eliminate 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 analysts’ 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 procedure 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,
JUNE 2015 / THE CPA JOURNAL
this addictive characteristic may be what
endangers the firm’s future.
Auditors need to be particularly cautious
when a client insists that things are turning around and will get better in the future,
particularly with respect to temporary cutbacks and crisis-based schemes advocated
by management. An auditor must carefully assess the motives behind such actions
in light of the real economic circumstances
confronting the company, industry, and
economy. It is especially important to question 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 gimmickry 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 function 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 improving 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
JUNE 2015 / THE CPA JOURNAL
reports because “it aggravates him”
(Cooper 115). Ebbers absorbed the idea
of an internal audit function, but neutralized it when it became threatening.
Assessment of ICFR is the central function of internal auditors. As Cooper put it,
“asking an internal auditor not use the words
‘internal controls’ is like asking a physician 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 company’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 pseudopodic ego. In their assessment of tone at
the top, auditors must pay particular
attention to management behavior that outwardly supports sound ICFR practices, but
in reality undermines their effectiveness.
External referencing. External referencing is judging success only by the perception of others. Of course, sound management practices dictate some level of
concern for how the organization is perceived by others, including current and
potential shareholders, customers, suppliers, regulators, and the general public. In
the addicted organization, however, managing the perception of others (particularly 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 appliance maker Sunbeam, the stock price soared
49%. Such was his celebrity that the mere
announcement of his hiring added $500 million 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 ensuing months, it was obvious that channel
stuffing was just one of the earnings management stratagems that Dunlap had fostered (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 bestselling 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
53
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 celebrated as Dunlap could have focused on
running Sunbeam effectively, trusting that
the stock market and analysts would recognize his superior performance in the
longer run. But instead, his short-term
manipulations sent the company into a tailspin from which Chapter 11 bankruptcy
was the only option (SEC Litigation
Release 17001).
Auditors must pay particula …
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