Toshiba Accounting Scandal Shows Tone From the Top Remains a Fraud Risk Factor
Once more a massive accounting fraud is galvanizing critics of corporate governance, both here and abroad, this time engagingly illuminated by the elaborately choreographed resignation of three top Toshiba Corporation executives following disclosure of a $1.2 billion profit overstatement reportedly occurring over a seven year period. Although details are still sketchy, the Financial Times cites an 82-page report prepared by a panel of external lawyers and accountants that details “institutional” accounting malpractices and a corrupt corporate culture. If true, the Toshiba accounting scandal will be one of a long string of financial reporting frauds, including such notorious cases as HealthSouth and WorldCom, in which top executives demanded that earnings expectations be met, whatever it took – and by the way, please don’t bore me, or incriminate me, with the details of how you did it!
Most of the major frauds that have been dissected over recent decades have, with benefit of hindsight, been accomplished via a small range of basic accounting distortions. For example, the $11 billion WorldCom fraud was effected though three simple devices, such as charging current period expenses to existing accruals that had previously been provided for unrelated costs, and capitalizing operating costs so that they could be deferred and amortized to expense over extended periods of time. Other notorious cases involved creation of “cookie jar” reserves, often in connection with business acquisitions, used to create fictitious earnings in later periods.
The Financial Times’ story on the Toshiba accounting situation states that cost overruns on various construction projects were not timely recognized, which probably means these were buried on the balance sheet despite not meeting the accounting definition of assets. The most recent prior Japanese financial reporting fraud, involving Olympus Corporation, was achieved by hiding investment losses incurred over many years in “off balance sheet” investments. Enron’s so-called “partnerships” similarly hid losses in non-consolidated investees. All of these involved violations of basic, well established accounting principles.
In all the classic formulations of internal accounting control, a key element is said to be “tone at the top.” The implication is that if top management shows disdain for compliance with the fine points of generally accepted accounting principles, or is known for such relatively minor infractions as the padding of expense reports, or – much more serious – makes demands, enforced by intimidating threats or actions, that key performance metrics be met regardless of what it takes to do so, then financial fraud is much more likely to occur. Richard Scrushy, founder and CEO of HealthSouth, Bernard Ebbers, chief of WorldCom, “Chainsaw Al” Dunlap of Sunbeam, and a whole host of other, once-lionized corporate leaders were known, well before their downfalls, as exuding charismatic charm wrapped around iron wills that none of their underlings dared dispute. And, indeed, those tyrannical CEOs did motivate their managers to commit fraud, in some instances for a decade or longer, before the schemes eventually proved unsustainable and collapsed, as almost all do.
“Tone at the top” is the standard appellation applied to this attribute, based on the generally valid observation that a rotten apple at the top will spoil the entire barrel, unless detected and corrected. It is true that underlings will often seek to emulate their superiors, and additionally will often see infractions by their leaders as offensive and envy-triggering, such that a “as long as they are getting away with these thefts or frauds, I also want, and deserve, my share of the spoils” attitude develops in the middle management ranks.
However, it has been observed that the tone at the top is not, per se, the real problem, because top management acting alone can do little damage. Rather, it is the tone from the top – i.e., the culture that trickles down through the organization – that actually affects the proclivity to engage in, or acquiesce to, financial reporting frauds that can destroy companies. If correct, this implicates a need to find the means to encourage, direct and measure the dissemination of appropriate internal control values and practices throughout the enterprise.
Whether called tone at or tone from the top, it is clear that corporate culture does play a disproportionate role in demanding, encouraging or permitting financial reporting fraud. Recent studies in human behavior, such as that identifying the so-called “dark triad” of personality types, including narcissistic traits of top management, shows promise of empowering independent auditors – who already are required to evaluate risks flowing from weaknesses in their clients’ internal controls as an input to audit scope decisions – with tools to more effectively accomplish fraud detection on a timely basis. Such developments will be difficult, but will be welcomed if and when they occur.
As the Toshiba accounting story unfolds, professional standards-setters and firms will gain further insights that hopefully will lead to enhanced auditing practices. It is likely to further underscore the need to effectively evaluate tone at, or from, the top.