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COPYRIGHT 2006 Aspen Publishers, Inc.
The authors review the need to examine corporate ethics and the current approaches to financial reporting, consider the various reasons inaccurate numbers are often supplied, and demonstrate how a positive, proactive approach, addressing the lack of personal ethics, can significantly reduce the situations that allow for fraudulent reporting and theft.
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Fraudulent reporting of financial data and theft is an equal opportunity curse that affects all businesses and cuts across all job classifications. From the janitor who has to report on the supplies inventory to the president who provides profit and loss information to shareholders, there are tendencies to fudge the numbers that one sends to supervisors or to the public for self interest motives. For some, there is a belief that numbers are malleable and can be used to say whatever one wants. Perhaps this old accountant joke reflects this conviction:
A corporate president is seeking to hire a new accountant. The president asks the first applicant what is one plus one. This applicant responds, "2." The president asks the second applicant the same question. This candidate for the job answers, "11." When the third applicant is asked the same question, he responds, "What number did you have in mind?"
The obvious punch line is that the third candidate is to be preferred, the one who is most creative with the numbers and will somehow be able to do whatever the president wants. In addition, this concept also suggests that playing with numbers to create a desired outcome is common practice without significant negative consequences. However, the corporate scandals that have rocked the financial markets caused by "creative accounting" to cover up bad economic news or theft have created a need to examine corporate ethical environments. They have also allowed this laissez faire attitude to perpetuate. It is critical that a business is able to rely on the numbers its employees pass up the corporate chain and that the public can better trust the numbers it is given. This article reviews the need to examine corporate ethics and the current approaches to reporting, considers the various reasons inaccurate numbers are often supplied, and demonstrates how a positive, proactive approach, addressing the lack of personal ethics, can significantly reduce the situations that allow for fraudulent reporting and theft.
REACTION TO THE RECENT SCANDALS
The rulemakers and professional organizations have reacted to the current financial scandals with the issuance of a slew of weighty pronouncements designed to avoid another Enron or WorldCom. This response suggests that more rules with stiff penalties will be sufficient to alter behavior. This article first examines the COSO Enterprise Risk Management Framework and the Sarbanes-Oxley Act. It then also reviews the general time tested procedures that attempt to screen and weed out potential employees who may be willing to engage in unethical, even illegal, activities.
COSO ENTERPRISE RISK MANAGEMENT FRAMEWORK
The Committee of Sponsoring Organizations (COSO) of the National Commission on Fraudulent Financial Reporting, also known as the Treadway (1) Commission, was formed in 1985 to identify causal factors leading to fraudulent financial reporting upon the heels of the savings and loan debacle. The committee is a voluntary private sector group supported by major professional organizations (2) dedicated to improving the quality of financial reporting through business ethics, effective internal controls, and corporate governance.
Though the project was underway prior to the 2002 reports on the corporate financial scandals, the COSO released an exposure draft of its risk management framework in July 2003. The enterprise risk management (ERM) framework builds on COSO's 1992 release on Internal Control-Integrated Framework. Thus the ERM framework has been dubbed COSO II. The current chair, John J. Flaherty, has stated that the goal is to provide organizations "... a commonly accepted model for discussing and evaluating an organization's risk management efforts." (3) The framework identified five interrelated components:
1. The control environment--the tone at the top;
2. Risk assessment--the identification of relevant risks in order to plan the management of them;
3.Control activities--procedures in place to carry out management directives;
4. Information and communication--the identification and dissemination of data to management to enable it to meet its responsibilities; and
5. Monitoring--reviewing and evaluating the functioning of the internal controls.
The components form "a system that can react dynamically to changing conditions." (4)
SARBANES-OXLEY ACT OF 2002
In July 2002, the Sarbanes-Oxley Act was enacted by Congress as a formal response to the corporate and accounting scandals. The NACUBO Advisory report on the Act states that its "... purpose is to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to securities laws." Thus the Act applies to SEC registrants. Accordingly, non-profit institutions would appear to be exempt. However, NACUBO maintains that the Act is relevant as an important guide even for non-profit institutions and especially to institutions of higher education. For example, bond rating agencies and insurers may include the adoption of certain provisions as best practices for members of boards of trustees; the expectations of the trustees, many of whom come from the corporate world, should be increased. (5)
Provisions of the Act that are considered to be particularly relevant are certain of those related to auditors, senior management, and audit committees. It has been suggested that audit committee charters and institutional codes of conduct be evaluated in light of Sarbanes. (6) Section 301 requires a confidential complaint mechanism to enable reporting of questionable accounting, internal control or auditing matters (i.e., an avenue for whistleblowers). This would include, of course, the follow-up of such complaints.
Section 404 of the Act requires an annual certification of the internal control environment of public companies. This requirement re-emphasizes the need to evaluate risk and control, which is often difficult when there is a collection of fairly autonomous program units. Documentation of the policies and procedures that provide the necessary "good business practices," are often an afterthought given the generally scarce resources available for both profit and non-profit institutions.
TIME TESTED PROCEDURES AIMED TO KEEP OUT UNETHICAL EMPLOYEES
Historically, issues of employee theft and misreporting are commonly addressed in a negative, reactive, three stage approach: keeping potential "bad people" out of a company, prevention and detection of a crime, and procedures used when an employee is caught stealing or misreporting.
Stage One: Keeping Potential "Bad People" Out of a Company
The first phase of theft and misreporting prevention is to keep criminals, potential thieves, and unethical employees out of the company. Most corporate pre-screening procedures include personal interviews, reference and credit checks, pencil and paper honesty tests, and polygraph tests in states deeming them legal. Prior to the Congressional prohibition of polygraph testing in 1989, lie detector tests were widely used by large corporations. After the ban, other tests, such as pen and paper quizzes and handwriting analysis were used as polygraph substitutes. Companies such as Nordstrom's for example, rely heavily on phase one pre-screening techniques. Nordstrom claims that their first phase of pre-employment, mostly background checks, can turn away 50 percent of all potential new hires. (7) Applicant credit and background checks raise red flags on employees who may have a high propensity for future theft. Employee pre-screening procedures often show indications of excessive employee debt, repeated check bouncing, and credit worthiness, which are all areas of particular interest to employers. (8) Today, however, many organizations are bound by legal restrictions and the threat of lawsuits, which limits their ability to gather employee information. (9) To date, employment verification laws are restrictive and an active area of debate. (10)
While most companies would agree that spotting a criminal without pre-screening techniques is virtually impossible, there is disagreement as to the effectiveness of individual detection and deterrent methods. Those in favor of pre-screening tests point to 1992 survey results completed by London House, the primary provider of Honesty Test forms, illustrating five major retail chains' shrinkage loss reduction by about 40 percent after two years of using pre-screening tests. (11) Similarly, PEOPLE (Psychological Evaluation Often Prevents Losses Early), is believed to be responsible for a reduction of 69.9 percent in terminations and prosecutions for theft. (12) In addition, an independent survey showed that honesty tests can successfully detect thieves among a group of convenience store employees. (13)
On the other hand, there are many critics of pre-screening techniques. For example, advocates are quick to claim that the side effects of such tests reduce employee morale. Many times the tests are conducted by untrained personnel and consequently improperly administered; as a result applicants are treated in a demeaning manher. (14) An honesty test also raises the question of whether the exceedingly subjective qualities of truthfulness and loyalty can actually be measured. Under such uncertainty many states, such as Massachusetts, have prohibited written tests on the grounds that the tests led to discrimination and invasion of privacy. (15) Similarly, independent surveys completed by...
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