The critical role of ethics: recent history has shown that when individual ethics are compromised, corporate ethics fail and financial disaster is not far behind

Internal Auditor, Dec, 2003 by Marianne M. Jennings

THE BUSINESS COMMUNITY IS MORE than familiar with the financial collapses of Adelphia Communications Corp., Tyco International Ltd., Global Crossing, WorldCom Inc., FINOVA Group Inc., Enron Corp., and HealthSouth Corp. Each company failed amidst allegations of financial mismanagement, poor decisions, and a lack of oversight. But the reality is that the tangible aspects of financial collapse begin with a severe erosion and eventual ruination of corporate and personal ethics. In other words, companies collapse ethically long before suffering financial demise.

In response to the magnitude of the collapses, as well as the sheer number of companies affected, the U.S. Congress passed the Sarbanes-Oxley Act of 2002 with record speed. Sarbanes-Oxley reforms represent the third great U.S. financial regulatory reform in the last 25 years. The first came as a result of the savings-and-loan (S&L) industry debacle and questions regarding the S&Ls' financial reports, including the values at which they were carrying assets. Following that series of reforms came the insider trading and junk bonds-collapses era of Dow Jones Index speculator Ivan Boesky and Michael Milken, a former executive of now-defunct Drexel Burnham Lambert Inc. "Never again" was the mantra of legislators and regulators as they undertook substantial reforms.

Yet, here we are--again. How do we prevent corporations and their management from trotting down these temporarily lucrative paths of fraud? What types of checks and balances could we create that would prevent such frauds? Or, if fraud cannot always be prevented, what could we implement to ensure that someone within the corporation raises a red flag before it faces bankruptcy?

Answering these questions requires a post-mortem analysis of the era that preceded reforms, which includes looking at three factors:

* The systemic failures that had to occur for these companies to reach the levels of fraudulent financial reporting that they did.

* The common traits of ethical collapse and the need for examination of qualitative factors that point to those traits.

* Prevention of such failures in the future by a focus on ethics and value-based decision-making.

THE SYSTEMIC FAILURES

For each of the recently collapsed companies to have arrived at the point of no return, six systemic components had to fail:

* The accountants.

* The auditors.

* The board.

* The business analysts.

* The business press.

* The investors' minds.

The list is reminiscent of U.S. District Court Judge Stanley Sporkin's poignant question as he viewed the rubble of the nation's savings and loans, "Where were these professionals when these clearly improper transactions were being consummated? Why didn't any of them speak up or disassociate themselves from the transactions?" Given the opportunity, surely Judge Sporkin would have gone on to ask: "Where did they learn this stuff?" and "Where were the absolutes and that bright line between right and wrong?"

? Where Were the Accountants?

Professor Richard Leftwich of the Graduate School of Business at the University of Chicago has commented that one of the problems with accounting and auditing is "hypertechnicality," a focus on technical compliance with the rules that begs the overall question of whether the result is financial statements that afford a fair picture of the company's financial position. On more than one occasion, Leftwich has noted wryly, "It takes the Financial Accounting Standards Board (FASB) two years to issue a ruling and the investment bankers two weeks to figure out a way around it."

Auditing and accounting rules have evolved to a quantitative rule of thumb for materiality when the qualitative factors often speak volumes about the financial condition of the company as well as management's integrity. For example, Sunbeam Inc., another of the financially and ethically collapsed companies, was desperate to meet its numbers for 1997. It entered into an agreement with EPI, a warehouse company, to sell its warranty parts for $11 million, a transaction that resulted in Sunbeam being able to show an $8 million profit rather than a loss. The parts, however, were worth only $2 million. The worth of the parts was irrelevant because the parties agreed to back out of the transaction in January 1998, once the profit for 1997 had been released.

Sunbeam's external auditor was aware of the transaction's tentative nature, but did not disclose it, because the amount involved was not material in terms of Sunbeam's total sales. However, the amount was material with regard to the financial condition of the company as well as the intent and integrity of management.

? Where Were the External Auditors?

There were two problems that plagued the external auditors of the recent scandalized companies and impeded their ability to demand changes and corrections in the financial reports. First was the independence of the external audit, because the audit firms were also performing consulting work for the same companies. In most cases, the consulting fees exceeded the audit fees. According to USA Today, in 2002, American Power Conversion, for example, had a 5-1 ratio of nonaudit fees to audit fees; Apple Computer's nonaudit-to-audit ratio was 12-to-6; retail giant The Gap's ratio was 13-to-5; and Kmart Corp. held a 10-4 ratio. The year before Enron's problems came to light, the energy giant paid former accounting firm Andersen $52 million: $27 million for its nonaudit work and $25 million for its audit work, which included tax and consulting services.