The root of corporate evil: executive compensation plans and overwhelming authority must be controlled through better governance mechanisms

Internal Auditor, Dec, 2004 by Douglas Guerrero

THE FINANCIAL FRAUDS PER-petrated by high-ranking corporate executives in the last few years were the catalysts for the passage of the U.S. Sarbanes-Oxley Act of 2002 and the creation of the Public Company Accounting Oversight Board (PCAOB). Sarbanes-Oxley focuses on financial reporting processes and controls, executive certifications of the financial statements and the processes that generate them, and audit committee governance responsibilities. The PCAOB regulates external auditing and specifies how audit firms must conduct audits of publicly listed companies. Taken together, Sarbanes-Oxley and the PCAOB are expected to significantly reduce the types of financial fraud exemplified by Enron, WorldCom, et al., and increase investor confidence in the accuracy and fairness of the financial statements and management's disclosures.

There has been much debate, however, regarding the efficacy and cost of both Sarbanes-Oxley and the PCAOB, with many suggesting that these were knee-jerk reactions that are proving costly compared to the benefits gained. Others firmly believe that these measures are fully justified and can deliver benefits to companies beyond mere compliance. I have yet another view: Although Sarbanes Oxley and the PCAOB are a move in the right direction, they don't go far enough to address the basic issues behind corporate malfeasance--greed, power, and weak internal controls.

Good controls assurance work demands the identification of root causes for control weaknesses found. The underlying premise is that only by correcting the root causes will the problems truly be solved. We have learned from fraud detection and investigation experiences that fraud is most likely to happen when three factors are present:

* Pressure or motivation. The perpetrator has significant reason to commit the fraud (e.g., debts, gambling or drug habits, or blackmail).

* Opportunity. Controls are weak or can be circumvented.

* Rationalization. There's a way for the perpetrator to live with the misdeed (e.g., "It's only a loan, I'll pay it back;" or, "The company owes it to me.").

It appears that a common theme among organizations guilty of fraudulent financial reporting is that one or more highly placed executives used their power to override normal processes to achieve financial targets fraudulently, boost the stock price, and further enrich themselves via compensation schemes that rewarded those achievements. In other words, some exceedingly greedy people abused their authority to deceive others for large personal gain.

So, the pressure or motivation is clear: huge personal financial gain, probably combined with egotism. The opportunity is also clear: They had enough authority and intimidation power to circumvent any controls necessary. The rationalization is less apparent, but I can imagine a few saying: "Everybody does it," "No one will ever find out," or "This is only temporary, we'll fix it when things get better."

Thus, the root causes for the frauds were 1) greed, fed by a tempting compensation plan that depended on making budget and being able to exercise stock options at selling prices much higher than the exercise price, and 2) overwhelming power and authority to intimidate others into performing actions not well understood or not to be questioned. There's probably not much that can be done about an executive's greed. But there's no reason why compensation plans could not be designed to minimize temptation or why over-whelming authority and power could not be checked by better governance mechanisms--consider the branches of the U.S. government. Although we already have checks and balances in the corporate world in the form of investors, management, boards of directors, and external auditors, clearly they have not been working very well.

In 2002, the Conference Board--a membership organization that creates and disseminates information about management and the marketplace to help businesses strengthen their performance--convened the Commission on Public Trust and Private Enterprise to address the circumstances that led to the corporate scandals of 2001 and 2002 and the subsequent decline of public and investor confidence in companies and the financial markets. The commission, composed of prominent leaders of the business world, released reports containing a series of recommendations and best practices dealing with three areas: executive compensation, corporate governance, and accounting and auditing issues. The commission issued its first report--on executive compensation--in September 2002 and the other two reports in January 2003. Findings from the reports include:

* "Recent survey data suggest that large numbers of people believe executives are willing to take improper actions to enrich themselves at the expense of the corporation and that chief executive officers [CEOs] of major corporations are not trustworthy."

* "In the area of executive compensation, the commission shares the public's anger over excessive compensation, especially with executives of failed or failing companies who may have garnered substantial compensation even as their companies and the retirement savings of their employees have collapsed."