eg and corporate fraud: is public opinion reconcilable ... · expectation gap and corporate fraud:...

Expectation Gap and Corporate Fraud:

Is Public Opinion Reconcilable with Auditors’ Duties?

Jeffrey Cohena, Yuan Dingb, Cédric Lesagec,* and Hervé Stolowyc aCarroll School of Management at Boston College, USA

bChina-Europe International Business School (CEIBS), Shanghai, China cHEC Paris, France

This draft – October 28, 2010 – Please do not cite or circulate without permission – Comments welcome Acknowledgments. Cédric Lesage and Hervé Stolowy acknowledge the financial support of the HEC

Foundation (Project F0802). They are members of the GREGHEC, CNRS Unit, UMR 2959. Yuan Ding acknowledges support from the CEIBS Research Funding and from Jiangsu Jinsheng Industry Co., Ltd. They also acknowledge Claire O’Hana for her able research assistance.

*Corresponding author: e-mail address: [email protected]

mailto:[email protected]



ABSTRACT. Based on evidence from press articles covering 39 corporate fraud cases that

went public during the period 1998-2005, the objective of this paper is to examine whether

the expectation gap between public opinion and auditing profession still exists and what are

the elements that illustrate the existence of such a gap. Results suggest that the expectation

gap still persists even after continuous efforts made by auditing profession to attenuate it. The

most salient elements demonstrating the gap are related to managers’ personality traits. It

appears that professional standards are reluctant to enumerate subjective personality traits as

these elements are difficult to audit in an objective way. Implications for practice and

research are discussed.

KEY WORDS: Expectation Gap; Corporate fraud, Personality traits, Fraud-related

professional standards

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Introduction

First conceptualized by Liggio (1974), the “expectation gap” (EG) could be defined as “the

differences between what the public expects from an audit and what the auditing profession

prefers the audit objectives to be” (Sikka et al., 1998). One of the most important issues

revolving around EG deals with auditors’ responsibilities for detecting and reporting fraud

(Humphrey et al., 1992; Power, 1997; Dewing & Russell, 2001; Zikmund, 2008) as the public

might view the audit as a guarantor against fraud while auditors view it as their professional

duty to investigate for fraud but not necessarily detect fraud in every instance.

The auditing profession regularly denounces EG because it damages their reputation and

increases their litigation risk (Kaplan, 1987; Reckers et al., 2007; Zhang, 2007). In 1988, the

AICPA issued auditing standards to attenuate the gap, amongst which the SAS 53 on fraud

detection. They have been called “the nine expectation gap SAS” (Reekers & Schultz, 1993),

as the profession wanted this new regulation to bridge EG. However, the auditing standard on

fraud detection (SAS 53) did not close EG as it was expected to (Herdman & Neary, 1988)

and the subsequent issuance by the AICPA of two more standards (SAS 82 in 1997 and SAS

99 in 2002) did not solve the issue neither (Zikmund, 2008).

The causes of the persistence of EG are not clearly evident in the research literature. On

one hand, many studies have tried to find causes from the side of auditing profession, like the

difficulties in assessing their work (McNair, 1991), the mutations over the time of the

auditor’s responsibilities (Burton & Fairfield, 1982; Brown & Burnaby, 1988; Tomassini,

1990; Huss, 1991; Humphrey et al., 1992; Mikol, 1993; Jeppesen, 1998; Sikka et al., 1998)

and the self-regulation feature of the profession (Humphrey et al., 1991; Humphrey et al.,

1992; Sikka et al., 1998). Power (1997) has also suggested that the reasons for the persistence

of the EG lie with the profession side, as it originates in the differences between the

operational level (the professional practice level characterized by precise audit tasks) and the

programmatic level (discourse of the profession characterized by broad goals and values). On

the other hand, the auditing profession blames the expectation gap on the public’s ignorance

of the audit function and their unreasonable expectations of the auditing profession in fraud

contexts (Kaplan, 1987; Singleton-Green, 1990; Humphrey et al., 1993).

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The objective of this study is to identify the most salient elements of the expectation gap

and so to answer the key question of whether the auditor’s conception of their work in

examining fraud is reconcilable with the public opinion’s expectation from a moral and

ethical lens.

As the basic concept of an expectation gap concerns differences in opinions between the

auditing profession’s view and the public’s view (Humphrey et al., 1992), we want to

investigate both sides of the expectation gap. The auditor’s side is mainly based on the

auditing standards as they reflect the auditors preference in a given political context (Sikka et

al., 1998). Regarding the “public side” of the expectation gap, we use press articles as a proxy

of public opinion since the extant literature mainly investigated through different occupational

groups: managers (Arrington et al., 1985), jurists (Jennings et al., 1993; Anderson et al.,

1998), corporate finance directors, investment analysts, bank lending officers and financial

journalists (Humphrey et al., 1993). To the best of our knowledge, we did not find any studies

investigating the “general public” expectations, although this notion is very present in the

professional discourses. In a speech entitled “Restoring Public Confidence”, Castellano,

former chairman of the AICPA, claims that “the AICPA shares the distress of all Americans

concerning the tragic breakdowns that contributed to the fall of Enron…[ and ]…is actively

engaged in supporting and implementing reforms on a number of fronts in an effort to restore

public confidence in the capital markets” (Castellano, 2002, p. 37-38, emphasis added).

Sutton, the former SEC chief accountant defined the expectation gap as the “gap between

what the ordinary person was thought to perceive as the auditor’s role and the responsibilities

the profession established for itself” (Anonymous, 1997, emphasis added).

Public opinion has been defined as beliefs, attitudes and opinions that people and/or a

society have towards a general (Tönnies, 1922). According to Tönnies, the public opinion is

defined by its consensual nature, strong or weak, and is characterized by being based on

values and broad principles (Palmer, 1938). The media acts as an indispensable agent of both

forming and reflecting public opinion (Lippman, 1922), since most of the people cannot or do

not have direct access to much of the world, Relating this to the audit expectation gap, these

concepts suggest that public opinion is therefore potentially reflected in the media coverage of

fraud cases. This is important because corporate crises seem to be the major determinant of

auditing regulation change (Tricker, 1982), as they attract public attention and raise new

expectations amongst the public. However, the public is rarely exposed to the actual output of

the auditing function as the audit reports have a very limited “circulation and readership”

(Humphrey et al., 1992, p. 149).

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Our study therefore investigates whether the auditor’s conception of their work, based on

precise and technical duties, is or is not reconcilable with the public opinion’s expectation as

characterized by general and moral values. A negative answer would provide evidence that

EG still persists despite the attempts at reform that the profession attempted to implement in

the late 1990’s and early 2000’s. We conduct a content analysis of press articles covering 39

high profile fraud cases. We then use the Porter’s (1993) total expectation gap decomposition

(sub-standard performance, deficient standards and unreasonable expectation), which we

detail by adding the fraud triangle framework outlined in SAS # 99 which posits that

corporate fraud is a function of incentives, opportunities and attitudes/rationalizations. We

then allocate each cited-by-media element according to these components. We identify the

corresponding red flags in the U.S. Statement on Auditing Standards (SAS). We therefore

distinguish: (1) items, such as the presence of stock options, that are cited in both media

coverage and SAS: these elements are partially identifiable as being objective (Level 1); (2)

items cited in both media coverage and SAS, but were not taken into account in the fraud

likelihood assessment by the auditors as these cases have been identified as audit failure

(Level 2); and (3) items cited in the media but not in the SAS that deal with issues such as

personality (Level 3).

We find that Level 1 components are mainly precise and objective elements, which

corresponds to the purpose of the profession to protect itself. We also find that Level 3

components are very hard to assess ex-ante by the auditors as they are mainly very subjective

and beyond their usual sphere of control. The items in Level 3 mainly express judgements of

value on the managers’ behaviour.

The results of our analysis confirm that EG will persist given the co-existence of both

legitimate behaviours that are inherently irreconcilable: (1) the rational auditor’s impossibility

to assess these very subjective components of fraudulent behavior if he/she wants to protect

himself/herself; (2) the essential attraction of public as demonstrated in the media for

judgement of values. We contribute to the existing literature on EG in the following ways.

First, our study is the first which considers the public opinion and not occupational group as

reflecting the public side of EG. Second, from a methodological perspective, unlike most

studies on EG which have relied upon questionnaires, we use content analysis to examine

documented cases of fraud which resulted in a manifestation of EG.

The remainder of this paper is organized as follows. The next section presents our

theoretical framework, which is based on the concepts of expectation gap and fraud triangle.

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The following sections discuss the research methodology and our results. The last section

presents a discussion with limitations and some directions for future research.

2. Expectation gap and corporate fraud: the theoretical framework

In this section, we define the concepts of the expectation gap, fraud and the “fraud triangle”

that led to the pertinent professional auditing standards regulation. Moreover, based on the

sociological perspective on the role of value judgements for the public, we also examine the

links among public opinion, media and public expectation on audit profession.

Importance of the expectation gap

The expectation gap has been identified as a major issue in auditing (Sikka et al., 1998).

Globally, EG results from the difference between public expectations and the profession

concerning assurances given by auditors following their auditing work. For instance, Sikka et

al. (1998) define EG as “the differences between what the public expects from an audit and

what the auditing profession prefers the audit objectives to be”. For example, the public might

view the audit as a guarantor against fraud while auditors view it as their professional duty to

investigate for fraud but not necessarily detect fraud. This difference was first conceptualized

by Liggio (1974), but its seems to have emerged along with modern auditing itself in the 19th

century (Humphrey & Turley, 1992).

A large number of empirical studies have tested and confirmed the existence of the audit

expectation gap (Wilcox & Smith, 1977; Arrington et al., 1983; Singleton-Green, 1990;

Humphrey et al., 1991; Benau et al., 1993; Humphrey et al., 1993; Porter, 1993; Warming-

Rasmussen & Jensen, 1998). The auditing profession regularly denounces EG because it

damages their reputation and increases their litigation risk (Kaplan, 1987; Reckers et al., 2007;

Zhang, 2007).

According to the profession, EG is mainly due to the misperceptions of the public for two

main reasons. First, the profession argues that audit reports users are largely ignorant of the

precise nature, goals, abilities and assurance of the audit function (Singleton-Green, 1990;

Humphrey et al., 1993). However, some studies have demonstrated that the public actually

knows the auditor’s duties quite well (CICA, 1988). Second, they claim that the public has

unreasonable expectations about the auditing profession, especially in fraud contexts

(Humphrey et al., 1993).

To the best of our knowledge, there is no study analyzing these “unreasonable”

expectations. The auditing profession’s view (Tricker, 1982) supports a public interest

perspective according to which EG results in a delayed understanding by the public of the

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regulatory changes made after corporate crises (e.g. major frauds) to correct a potential failure

by the auditing profession. For example, there is a very strong correspondence between

periods of high activity in audit standard setting and the periods of major fraud-related crisis

seems to evidence this profession’s view. As stated by Humphrey et al. (1992, p. 138), “this

view implies a profession gradually and constructively responding to the changing

expectations of society”.

Beyond the traditional profession’s explanation, many studies have focused on

understanding its causes by analyzing different features of the auditing profession: difficulties

in assessing the auditor’s work (McNair, 1991), mutations over time of the auditor’s

responsibilities (Burton & Fairfield, 1982; Brown & Burnaby, 1988; Tomassini, 1990; Huss,

1991; Humphrey et al., 1992; Mikol, 1993; Jeppesen, 1998; Sikka et al., 1998), and self-

regulation by the profession (Humphrey et al., 1991; Humphrey et al., 1992; Sikka et al.,

1998). Whatever the identified causes are, regulators and lawmakers have long attempted to

address the auditing profession’s concern especially in the fraud context (e.g., Commission on

Auditors’ Responsibilities 1978; AICPA 1993; U.S. Government Accounting Office 1996).

Fraud and the expectation gap

One of the most important issues revolving around EG deals with auditors’ responsibilities for

detecting and reporting fraud (Humphrey et al., 1992; Power, 1997; Dewing & Russell, 2001;

Zikmund, 2008). Recent history of auditing standards about auditor’s responsibility to detect

fraud illustrates this moving power balance between both parts of the expectation gap: public

expectations and auditors’ duties. Auditors have historically built their legitimacy on fraud

detection (Carpenter & Dirsmith, 1993). However, auditors have then tried to (and largely

succeeded in) absolving themselves of this responsibility (Humphrey et al., 1992).

Unfortunately, this abdication of responsibility, has in turn historically confused the audit

reports users which has resulted in a cycle of never ending expectation gaps (Lin & Chen,

2004).

In 1988, the AICPA issued new auditing standards which have been called “the nine

expectation gap SAS” (Reekers & Schultz, 1993), as the profession wanted these new

regulation to bridge the expectation gap. One of them (SAS 53) required auditors to state that

they have actively looked for fraud (Guy & Sullivan, 1988). This change was a major step in

the efforts of AICPA to clarify the auditor’s responsibility and the meaning of an audit

(Anonymous, 1991). Unfortunately, it has been then argued that these new duties increased

instead of decreased EG (Anonymous, 1991): the efforts of the profession to bridge EG have

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generated “misinformed views” that have increased public expectations about auditor’s duty

to detect fraud. In the subsequent years, with the issuance by the AICPA of two more

standards (SAS 82 in 1997 and SAS 99 in 2002) that reinforce the auditor’s involvement in

the search for fraud, the profession tends to believe EG may be reduced by better developing

the auditor’s ability and efforts to detect fraud. (Zikmund, 2008).

Why does the profession apparent understanding of the necessity of changes not resolve

the expectation gap? In a review over 100 years in the anglo-saxon (mainly U.K. but also U.S.

and Canada) auditing profession, Humphrey et al. (1992) provide evidence that the

expectation gap has been evoked in the late 19th century, and is still present: “Rather than the

gap reducing as a result of past changes and responses, it obstinately remains unbridged and

appears to be as large in the 1990s as it was in the 1880s.” (Humphrey et al., 1992, p. 142).

The auditing standards as a political outcome

Humphrey et al. (1992) explain that the controversial nature of the auditor’s responsibility

for fraud detection has been constructed by the profession itself. The authors illustrate their

argument by studying the history of the regulation on the auditor’s role in the fraud detection

in the U.K. Since the late 1880s to the 1940s the detection of fraud has been considered by the

profession as the primary objective of the audit (Brown, 1962). The switch which occurred in

the 1950s has been officially made on behalf of a priority given to the fairness of financial

representation. However, some authors suggested that some fraud-related famous corporate

scandals in the 1950s have so much damaged the auditor’s reputation that the profession

wanted to downplay its responsibilities in the fraud detection (Brown, 1962). Then, following

the corporate scandals of the 1980s, the pressure on auditors has continuously revealed the

reluctance of the auditing profession to extend any responsibility in fraud detection

(Humphrey et al., 1991).

According to Humphrey et al. (1992), the profession plays a proactive role in the cycle

“crisis - public demand - change in regulation”. After a highly publicized accounting fraud,

the succeeding period of reflection and regulation changes appears to be mainly driven by the

auditing profession’s self-interest. Not having considered the “interested nature of the audit

profession in both framing the content of the expectation gap and in making and

implementing recommendations and strategies designed to close the gap” (Humphrey et al.,

1992, p. 156) may lead to a misconception of the nature of EG, which makes it impossible to

close.

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This argument is also developed by Sikka et al. (1998) who argue that the usual

definitions of EG are dissociated from their historical and political context. Sikka et al. (1998)

explain EG as a function of the moving meaning of the fraud detection role by the auditors in

the U.K. during the 1980s and 1990s (Singleton-Green, 1990). Sikka et al. (1998) conclude

that EG cannot be eliminated because it results from these social practices subject to a

continuous process of negotiation / transformation. The meaning of the audit is a permanent

political negotiation process with the “significant others” politicians, governments, etc. to

preserve their political power (Fogarty et al., 1991).

Auditing standards reflect therefore the auditors’ preference in a given political context

(Sikka et al., 1998): as any social practices, auditing standards and auditing profession protect

their self-interests (Parker, 1994; Bazerman et al., 2006). Thus, prior literature suggests that

EG may be not necessarily related to the public’s ignorance or to their “unreasonable”

expectations but better to the self-regulated auditing profession (Humphrey et al., 1992; Sikka

et al., 1992; Humphrey et al., 1993) who seeks to downplay as much as politically possible its

role in actively searching for fraud to better protect its interests.

Corporate fraud and the fraud triangle

We are interested in accounting or corporate “fraud”, as defined in SAS No. 99 (AICPA, 2002,

Para. 5): “fraud is an intentional act that results in a material misstatement in financial

statements that are the subject of an audit”. Two types of misstatements are relevant to the

auditor’s consideration of fraud—misstatements arising from fraudulent financial reporting

and misstatements arising from misappropriation of assets (AICPA, 2002, Para. 6). In this

paper, all of the cases that are examined represent documented examples of fraudulent

financial reporting. We are interested in this type of fraud as this often affects many

stakeholders (Cohen & Martinov Bennie, 2006).

In the previous literature, decomposing overall fraud-risk assessments into separate

assessments for management’s (1) incentives/pressures, (2) opportunities and (3)

rationalizations/attitudes is often referred to as the fraud-triangle decomposition (Wilks &

Zimbelman, 2004) or, in short, the fraud triangle.1 These elements were first identified by

Sutherland (1949), and developed by Cressey (1953, p. 30).2 Albrecht et al. (1982, p. 37)

adapted the concept from criminology to accounting and combined the fraud-related variables

1 Loebbecke et al. (1989) use a reasoning equivalent to the “fraud triangle” and call it a “model”. 2 Albrecht et al. (1982, p. 34) and Comer (1977, p. 10-11) present Cressey’s theory.

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into three categories: situational pressures, opportunities to commit fraud and personal

integrity (character).

Auditing regulation (AICPA, 1988, 1997, 2002; IFAC (International Federation of

Accountants), 2005) has outlined numerous fraud-risk factors. These indicators are also called

“red flags” and represent “potential symptoms existing within the company’s business

environment that would indicate a higher risk of an intentional misstatement of the financial

statements” (Price Waterhouse, 1985, p. 31; Pincus, 1989, p. 154). Compared to its

predecessors, the most recent standard, SAS No. 99 (AICPA, 2002, Para. 7) has structured the

risk factors around three conditions generally present when fraud occurs. “First, management

or other employees have an incentive or are under pressure, which provides a reason to

commit fraud. Second, circumstances exist—for example, the absence of controls, ineffective

controls, or the ability of management to override controls—that provide an opportunity for a

fraud to be perpetrated. Third, those involved are able to rationalize committing a fraudulent

act. Some individuals possess an attitude, character, or set of ethical values that allow them to

knowingly and intentionally commit a dishonest act” (italics in the original text). These

definitions are directly linked to the fraud triangle. Thus, the fraud triangle can help predict

the context in which managers may perpetuate fraud. Appendix 1 lists the “examples of risk

factors” provided in SAS 99 and ISA 240.

Public opinion, media and “unreasonable expectations”

Public opinion is generally defined as beliefs, attitudes and opinions that people or a society

has towards a general issue (Tönnies, 1922; Palmer, 1938). The media acts as an

indispensable agent of forming and reflecting public opinion. Lippman (1922) said it best

when he entitled the chapter one of his book as "the world outside and the pictures in our

heads.” He described a triangular relationship between the scene of action, perceptions of that

scene presented by the mass media, and responses based on the perceptions by people.

On one hand, many academic studies proved empirically how the media forms public

opinion (e.g., Barker & Knight, 2000, p. 167-168). For instance Johnson et al. (2005) discuss

that the financial press may have two roles: (1) information broker, recording and

disseminating information about business activities and (2) active participant in the

development of society’s awareness, understanding, and evaluation of businesses and

business practices. This influence is even more predominant in our particular context because

of the huge information asymmetry between the daily life of general public and corporate

world. In fact, the complex nature of the corporate frauds offers an opportunity to the media

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to play a more preponderant role in forming the public opinion on this issue. As defined by

Lippman (1922)’s triangular relationship, very few people in the society experience the board

meetings, make decisions with billion dollars on the stake, interact with complex network, or

understand sophisticated accounting and finance instruments. In short, the real corporate

world is unknown and even somehow mysterious for the public. As a consequence, media

naturally plays a much more important role in presenting the perceptions of the action (the

corporate frauds in our case) in a manner that is understandable by the public.

Further, the sociological literature identifies the agenda-setting function of mass media:

“The mass media force attention to certain issues. They build up public images of political

figures. They are constantly presenting objects suggesting what individuals in the mass should

think about, know about, have feelings about” (McCombs & Shaw, 1972, p. 177). Besides the

technical and legal aspects of corporate frauds, press articles could provide some journalistic

investigation on the personal traits of executives involved in these fraud cases. These add-on

perceptions make the stories more convincing and also more understandable for the public.

For example, if the media portrays the cases in personality terms, this could be in line with the

public fundamental beliefs as many in the public believe these cheating executives must have

some unique personal traits common to bad persons. Also, the media’s influence on public

opinion is heightened when the media reports negative news than when it reports positive

news which in this study would manifest itself by the media emphasizing the managers’

personal traits to justify why they committed frauds. Under such an influence, public opinion

could adjust its position toward this direction and therefore forge a stronger expectation on the

inclusion of these executives’ personal traits into auditors’ work.

On the other hand, the media reflects public opinion and functions as a monitor on behave

of the general public. Media’s role as a monitor for accounting fraud has been recently studied

(Miller, 2006; Dyck et al., 2007) and has been shown to be important due to the pressure it

places on management (Dyck et al., 2008).3 As over-mentioned, in order to understand EG

studying fraud is important because corporate crises seem to be the major determinant of

auditing regulation change (Tricker, 1982), as they attract public attention and raise new

expectations amongst the public. Meanwhile, the public is rarely exposed to the actual output

of the auditing function as the audit reports have a very limited “circulation and readership”

(Humphrey et al., 1992, p. 149).

3 We do acknowledge in the discussion section some potential limitations of press coverage.

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Collectively, as prior literature suggests understanding EG as manifested in corporate

fraud, it is then necessary to evaluate the press coverage of documented fraud cases. Unlike

previous studies which were based on questionnaires, we focus on the media coverage of

highly publicized accounting fraud cases as the way to operationalize the public’s

expectations. Even if the public has a distorted and unrealistic image of the auditor’s duties,

public opinion is potentially reflected in the media coverage of fraud cases.

Research question

Based on the above literature review, we find there is a potential of incorporating more

strongly the public opinion seen through the press, into the expectation gap concept.

Therefore, in this paper, we will examine the following overarching research questions (RQs):

RQ1: Does the expectation gap in relation to fraud detection, as evidenced by discussion of

the fraud, still exist?

RQ2: What are the specific elements in regards to fraud detection that demonstrates that the

expectation gap to exist?

Thus, the focus of the study is to identify, through a review of press articles related to fraud

cases, the fraud factors in which public expectations and the auditors’ duties differ.

3. Research design

Proposed analytical framework

Porter (1993) decomposes EG into the performance gap and the reasonableness gap.

Performance gap is a gap between what the society expects auditors to achieve and what they

can reasonably be expected to accomplish. Reasonableness gap is a gap between what the

society can reasonably expect auditors to accomplish and what they are perceived to achieve.

Porter analyzes the total expectation gap into three separate components: sub-standard

performance (16%), deficient standards (50%) and unreasonable expectations (34%). Based

on the previous developments and on Porter’s framework, Figure 1 details the combination of

the fraud triangle and the expectation gap.

***Insert Figure 1 About Here***

Sampling

To complement prior literature (Carpenter & Reimers, 2005; Gillett & Uddin, 2005), we

examine documented behaviors in 39 cases of corporate scandals, using hand collected

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evidence taken from press articles such as managers’ quotes and journalists’ analyses. In this

study, we take the media coverage as a proxy for the public expectations (see above), and the

auditing standards as a proxy for the auditors preference in a given political context (Sikka et

al., 1998).

To design our sample, we started from the Corporate Scandal Fact Sheet4, which includes

a list of 61 short vignettes on companies. Compared to a similar list maintained by Forbes5,

this list’s main advantage is that it includes the names of the main characters involved in the

scandals. We deleted from this list several companies which are linked to other companies

involved in different scandals: accounting firms (e.g., Andersen, KPMG) and banks (e.g.,

Citigroup, Morgan Stanley). We also deleted companies that had no data available on the

personality of the managers (e.g., Cornell). Finally, we added three companies that do not

appear in the Corporate Scandal Fact Sheet but which had received a lot of adverse publicity

and for which press articles were available (AIG, Delphi and Freddie Mac). The resulting

sample includes 39 fraud companies for the period 1998-2005. For the sake of comparability

in interpretation, we only used U.S. cases. Because the corporate scandal was mainly based in

its U.S. subsidiary – U.S. Food Service, we also included Royal Ahold, although it is a Dutch

group.

Content analysis

To evaluate the research question, we applied a content analysis of press articles. Content

analysis is a “research method which draws inferences from data by systematically identifying

characteristics within the data” (Jones & Shoemaker, 1994). It presents the following

advantages (Kabanoff et al., 1995): (1) non obtrusive characteristic (documents can be

evaluated without the knowledge of the communicator), (2) use of a natural verbal expression

as data base, (3) adaptability in longitudinal studies if texts are presented over long periods, (4)

systematic and quantitative approach applied to qualitative data. A thematic analysis (which is

the approach that we apply) enables the researchers to identify the content categories and

trends from the text, and then draw inferences from them (Jones & Shoemaker, 1994).

In terms of data analyzed, we searched for evidence from the U.S. press coverage in the

Factiva database.6 We also used SEC documents, to understand the technical and accounting

4 Available at the following address: http://www.citizenworks.org/corp/corp-scandal.php. 5 Available at the following address: http://www.forbes.com/2002/07/25/accountingtracker.html. 6 Factiva (also called Dow Jones Factiva) is a non-academic database of international news containing 20,000 worldwide full text publications including The Financial Times, The Wall Street Journal, as well as the continuous information from Reuters, Dow Jones, and the Associated Press (see

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aspects of the corporate fraud. For some companies (Adelphia Communications, Enron,

MicroStrategy, Rite Aid, Sunbeam, Waste Management, and Xerox), we also used the GAO

report (United States General Accounting Office, 2002) on restatements.

In order to identify the relevant press articles, we applied the following methodology. For

each case study, we first found the name of the managers involved in the fraud with the help

of the Corporate Scandal Fact Sheet or a search in Factiva on the company itself. As a second

step, we searched in Factiva with the name of the company and of the company’s managers as

key words. Keeping in mind that our objective was to find motivations of managers, we

selected the articles that included details about the personality of the managers.

The next step was the identification in each article of the paragraphs dealing with the

topics of interest for us. Once these sections were identified, a coding sheet was applied to the

content analyzed. This sheet has the same format as Appendix 3 which isolates the three main

influences known to be indicators of corporate fraud according to the fraud triangle

(Incentives, Opportunities, Attitudes/rationalizations) as well as the elements of the

expectation gap (deficient performance, deficient standards and unreasonable expectations).

To enhance inter-coder reliability, two different researchers analyzed separately the same

press articles on a sample of 10 cases. The major issue was the extraction of the relevant

pieces of information from the articles and the allocation of these pieces of information to the

columns of Appendix 3. The result was a 95% rate of convergence which indicates that the

coding showed strong signs of reliability.

4. Expectation gap in cases of corporate scandals: Analysis of the results

Recall that RQ 1 asks whether the expectation gap persists, while RQ 2 asks what are the

specific elements that demonstrate that the expectation gap still persists. Appendix 2 presents

a table disclosing years when the scandal went public and the number of articles used in each

case study. It shows that there is no apparent discrepancy between the cases in terms of

number of articles used (average 3.7 articles, minimum = 2, maximum = 6). Appendix 3

presents a detailed analysis of the 39 corporate scandals. The components are classified

according to the combination of fraud triangle and expectation gap (see Figure 1): Incentives-

pressures (col. 1), opportunities (col. 2), attitudes/rationalizations (col. 3), deficient

performance gap (audit failure) (col. 4), deficient standard gap (col. 5) and unreasonable

http://factiva.com/index_i7_w.asp). See http://factiva.com/index_i7_w.asp. Factiva is equivalent to the Lexis-Nexis database in terms of research tool.

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http://factiva.com/index_i7_w.asp

http://factiva.com/index_i7_w.asp

expectation gap (col. 6). The numbers displayed after each element of Appendix 3 refer to the

“examples of risk factors” listed in Appendix 1.

We identify two categories of components:

- Level 1 components: they are cited in both media coverage and the auditing standards:

these elements are partially identifiable as being objective (e.g. presence of stock-option

plans, etc.); they correspond to the columns 1 to 3 of Appendix 3,

- Level 2 components: they are also cited both media coverage and auditing standards, but

were not taken into account in the fraud likelihood assessment by the auditors as these

cases have been identified as audit failure; they appear in column 4.

- Level 3 components: they are cited in the media but not in the auditing standards (e.g.,

personal traits of personality, way of living, etc.). We find that Level 3 components

document that EG exists and what are the factors causing it. The level 3 components can

be sub-divided in two parts:

Column 5 of Appendix 3: Corresponds to the deficient-standards gap. The origin of

the gap stems from deficiencies in the auditing standards. As discussed below, they

are mainly related to the lack of definition of certain concepts and coverage

divergence between SAS and ISA.

Column 6 of Appendix 3: Corresponds to the reasonableness gap. This refers to what

the society can reasonably expect auditors to accomplish and what they are perceived

to achieve.

Level 1 components: the fraud triangle

Table 1 summarizes the explanation of fraud behaviors present in the auditing standards

(fraud triangle). It refers to columns 1 (incentives/pressures), 2 (opportunities) and 3

(attitudes/rationalizations) of Appendix 3. These explanations represent Level 1 components,

as defined above. As they are mentioned in the auditing standards and in the press, they do

not represent an expectation gap.

*** Insert Table 1 About Here***

Level 2 components: Deficient performance gap

In several instances, the auditing standards were not taken into account in the fraud likelihood

assessment by the auditors and the auditor’s alleged failure was identified. They are displayed

in column 4 (e.g., Cendant, Delphi, Halliburton, HPL Technologies, Merck, Sunbeam, Tyco,

14

Waste Management, Xerox). Again, since this was an auditing standard, cases in level 2 do

not represent an expectation gap.

Level 3 components (Column 5): Deficient standards gap

In column 5 of Appendix 3, we find elements cited by the press and not present in the

standards. Cases found here are examples of the manifestation of the expectation gap (RQ1).

We also identify two sources of explanations for this difference (RQ2): 1) Definition of the

concept of “rationalization” which is not developed in the auditing standards (SAS 99); and (2)

Differences between SAS 99 and ISA 240 (see Appendix 1). These items are summarized in

Table 2.

*** Insert Table 2 About Here ***

Rationalization

Although the auditing standard SAS 99 (AICPA, 2002) quotes 16 times the terms

“rationalize” or “rationalizations”, it does not provide a precise definition of the concept of

“rationalizations” but simply refers to “rationalizations to justify a fraudulent action” (§ 31).

All the examples of the section “Attitudes/Rationalizations” provided in the appendix of SAS

99 and reproduced in Appendix 1 of this article refer to “attitudes” and not a single one seems

to refer to “rationalizations”. As additional evidence, the word search in the SAS 99 text for

“charity”7 does not generate a single occurrence.

Given this lack of definition, we refer to Anand et al. (2005, p. 9) who define

rationalizations as “mental strategies that allow employees (and other around them) to view

their corrupt acts as justified” and add that individuals use rationalizations to “neutralize their

negative feelings or regrets about their behavior” (p. 10). Ashforth and Anand (2003)

identified several rationalization tactics. Among these, we identify the “metaphor of the

ledger”, or “balancing the ledger”, using the terms of Anand et al. (2005, p. 13), where “good

works (whether actual or anticipated) earn a credit that can be used to offset corrupt acts”

(Ashforth & Anand, 2003, p. 21). These authors include the donation of corporate funds to

charity as belonging to this rationalization technique.

We identified one major argument put forward by managers which ameliorated their guilt:

the fact that their actions helped other people or organizations via their work with charitable

causes (Adelphia Communications, Computer Associates, Enron, Freddie Mac, HealthSouth,

7 There is one occurrence of the term “charitable” but it is not related to “rationalization”.

15

and WorldCom) or the fact that the managers felt that they were acting for the good of the

company (Ahold).

Difference SAS 99 – ISA 240

Taking SAS 99 as a benchmark, we find a difference between SAS 99 and ISA 240, which

concerns mainly the fact that “the owner-manager makes no distinction between personal and

business transactions”. It should be noted that this example taken from ISA 240 could also be

considered as a case of misappropriation of assets. Interestingly, we found several instances of

the use of personal expenses paid for by the company’s resources (Cendant, Enron, Global

Crossing, HealthSouth, K-Mart, Peregrine Systems, Phar-Mor, and Tyco). In Adelphia

Communications, the fraud consisted of the improper use of the company’s funds for self-

dealing by the Rigas family. The money was used to buy stock and luxury condominiums in

Mexico, Colorado and New York City, to construct a golf course, to purchase timber rights to

land in Pennsylvania and to pay off margin loans.8 Thus, the absence in SAS 99 of the

example of the owner/manger making no distinction suggests that EG in that element is more

pronounced in the US (RQ2).

Level 3 components (Column 6): Unreasonable expectations

Table 3 summarizes the elements of fraud behavior not present in auditing standards which

are identified by the press and thus constitute the reasonableness gap of the overall

expectation gap. They are displayed in column 6 of Appendix 3.

*** Insert Table 3 About Here ***

The first category of explanations not present in auditing standards but present in media

coverage relates to maintaining a high living standard, sometimes linked to a passion for

sports. Anecdotal evidence exists in the press to highlight this element. For example, former

Tyco CEO Dennis Kozlowski acquired a “$6,000 shower curtain for his highfalutin

apartment” (Jennings, 2006, p. 2-3). Several CEOs had a real passion for sports which

perhaps influenced them to commit fraud. For example, Mickey Monus “borrowed” about ten

million dollars of Phar-Mor’s funds to cover the debts of the World Basketball League.

Several managers of the studied firms also received glowing praise and admiration from the

press. For example, prior to the scandals, Cal Turner, Dollar General’s CEO, was considered a

8 Caruso, D.B. (2002). ‘For years, Rigas treated Adelphia like a family business’. Associated Press Newswires, May 25. Anonymous (2002). ‘Adelphia Founder Reports Health Woes’. AP Online, June 30.

16

“marketing genius,”9 while Jeffrey Citron (Datek Online) had been heralded as a “technology

wizard” by Forbes magazine and as “one of the 20 most important players on the financial

Web” by Institutional Investor.10 Corporate America treated Al Dunlap [Sunbeam’s CEO

known as “Chainsaw Al”] as “a miracle worker and he did everything possible to promote this

image”.11 It appears that the managers believed in their own press and were willing to do

almost anything to keep up the favorable image. Finally, several egregious personality traits

are also found in the CEOs involved in the cases studied. Network Associates’ CEO, Bill

Larson, is a good example of tyrannical behavior.12 In the grand jury indictment, Martin

Grass (Rite Aid Corporation) “emerged as an arrogant bully, pressuring underlings to endorse

phony documents and bragging that cover-ups would never be discovered”.13

Thus, the elements in Level 3 document the existence of an expectation gap (RQ1) and

what are the elements documented in the press and absent in auditing standards (RQ2).

This finding is in line with the agenda-setting function of mass media we reviewed in the

previous section. Since the media focuses on managers’ personal traits when describing

corporate fraud, this in turn could lead to the strengthening of the public focus on this issue

(Davisdon 1983). Even if the repetitive media reports on the link between corporate frauds

and managers’ personal traits have few effects on changing the attitudes of many people, they

may still influence the consensus of public opinion on this issue. This is described as “the

action-inducing potential of the third-person effect” (Davison, 1983). In our case, given the

link between corporate frauds and managers’ personal traits in the coverage by the media,

public opinion should adjust its position toward this direction and therefore forge a stronger

expectation on the inclusion of these aspects into auditors’ work. “Perceptions of public

opinion, not only the actual distribution of opinion in the population, have long been

considered an essential part of public opinion dynamics: political behavior is shaped not only

by what people think, but also by what they perceive that others think” (Cohen et al., 2008, p.

340).

9 Chad Terhune, C. & Lublin J.S. (2002). ‘Unlike others, Dollar General issues a mea culpa --- Amid Enron, other scandals, discount retailer apologizes for its accounting problems’. The Wall Street Journal, January 17, B1. 10 Ahrens, F. (2002). ‘History of conflict for ex-Rite Aid chief; Indictment paints picture of grass as an arrogant bully’. The Washington Post, June 22, E1. Barboza, D. (1998). ‘He’s dazzled Wall Street, but the ghosts of his company may haunt his future’. The New York Times, May 10, 1. 11 Stewart, C. (1998). ‘Live by Chainsaw, die by Chainsaw’. The Australian, June 20, 1. 12 Ackerman; E. and Kang, C. 2001, ‘Silicon valley software company sinks under its own ambition’. Knight Ridder Tribune Business News, February 15. 13 Ahrens, F. (2002). ‘History of conflict for ex-Rite Aid chief; Indictment paints picture of grass as an arrogant bully’. The Washington Post, June 22, E1.

17

5. Discussion and limitations

The objective of this study is to examine through the analysis of press coverage of

documented whether EG exists (RQ1) and if so, what are the elements that there appears to be

a divergence between the public expectation and what the auditing standards highlight.. We

find that within Level 3 components (columns 5 and 6 of Appendix 3), components of column

5, which represent “deficient standards”, are mainly precise and objective elements, which

corresponds to the purpose of the profession to protect itself. Conversely, we find that Level 3

components, column 6, which represent the “unreasonable expectation gap”, are very hard to

assess ex-ante by the auditors as they are mainly very subjective and beyond their usual

sphere of control (personal traits of personality, way of living, etc.). They mainly express

judgements of values on the managers’ behaviour. However, if we accept the premise that the

media is a surrogate for the public’s expectations then the lack of the ability for the auditing

profession to objectively evaluate personality traits suggests that EG will continue to exist. In

fact, the public opinion is based on general values regarding the corporate frauds, while

auditors are working on the technical aspects of these cases. Therefore, it seems to be hardly

possible to reconcile the positions of the two parties.

Given the public’s desire for the auditing profession to evaluate subjective concepts like

personality and attitude, what can be done to narrow or even bridge the gap? One approach

may be for the auditing profession to enumerate some of these “soft’ factors that auditors

must exercise their professional judgment on. For example, some fraud-risk factors that were

highlighted by the press could be included in the SAS 99 and ISA 240 appendices:

- The manager has a very high living standard that could lead him/her to

unethical/fraudulent decisions.

- The manager has a personality, namely tyrannical or autocratic, that does not favor a

collective and sound culture in the firm. This personality makes it difficult to promote an

honest dialogue between all levels of the hierarchy.

- The manager has benefited from articles of praise from the press. This situation, which is

not problematic per se, has potentially given the manager an overestimated opinion of

himself/herself that may at times lead to promoting one’s press at any cost. The manager

has lost perspective about his/her authority and judgment even being questioned.

- The manager has benefited from a dominant position vis à vis other employees. This

situation is not problematic per se. However, the employees have such a respect for their

manager (or are so impressed) that some checks and balances might disappear. The

18

employees cannot critically evaluate what the manager requires from them is unethical or

fraudulent.

The examination of these subjective factors could be integrated within the control

environment audit mandated by the Sarbanes-Oxley Act (U.S. Congress, 2002) in section 404.

The audit requires auditors to evaluate controls via a framework which lists management

control philosophy as an important element of the control environment. In addition to controls,

auditors could examine on every audit what aspects of management’s personality may have

the potential to compromise the organization’s “tone at the top.” For example, if top

management is heavily involved with professional sports perhaps this could lead to a blurring

of the line between personal and corporate business. Auditors must go beyond what can be

objectively assessed (as evidenced by our Level 1 elements) but they must be vigilant to show

a healthy professional skepticism towards management’s personality that could bleed over to

the client’s business affairs (Nelson 2009).

Finally, as in all studies, there are potential limitations that represent opportunities for

future research. First, the red flags identified from the press and highlighted in column 6 of

Appendix 6 will not always lead to corporate fraud. The majority of managers who have a

high standard of living and have been identified as high-profile leaders will probably not

engage in fraudulent acts. Future research can explore the boundaries of when this lifestyle

will lead to unethical behavior. Perhaps if the economy is in a recession, the management of

the client may be more susceptible to fraud in order to maintain their current lifestyle.

Second, another limitation is related to the ex-post rationalization phenomenon and to

press coverage. Newspapers do shape people’s worldviews but news itself is managed,

manufactured and selectively produced. We do not underestimate the desire of newspapers to

glamorize fraud cases and to establish lively stories that contain colorful motives and are

populated with dramatic personalities. However, the press articles are generally based on facts

and actual testimonies which work to reduce the weight of the rationalization. For example,

Choo and Tan (2007) also used anecdotal elements in their research mentioned earlier. A

future study could examine if the press coverage depends on the amount of advertising firms

do with a particular media outlet.

Third, we are aware that, given the politics of rulemaking, standard setters are obliged to

accommodate some demands and proceed in an incremental way. In addition, we must

acknowledge standard setters realize the inherent difficulty (and sometime impossibility) of

assessing the personality and ethics of client personnel. Unless dysfunctional personality and

ethics are accompanied by behavior, there is a risk that these traits will go largely un-assessed

19

and un-addressed. However, future research can examine how the threat of litigation may

affect what the profession publicly promulgates what auditors are responsible for.

Finally, for the sake of simplicity and consistency, we focused on U.S. cases of alleged or

acknowledged corporate frauds. However, fraud is of course not limited to the U.S. and many

countries have faced similar situations. It would be interesting to extend the scope of study to

non-U.S. companies (e.g., Parmalat14 – Italy –, Shell15 – U.K./Netherlands, Marionnaud16 –

France, etc.) to investigate the robustness of our results in different cultural and institutional

contexts.

Despite the limitations, this study adds to the literature on EG by documenting its

existence in the most recent spate of corporate scandals in the late 1990’s and early 2000’s.

We have also shown that personality elements seem to be at the forefront of the expectation

gap. If auditors actively search for these factors and exercise their professional judgment, then

perhaps the expectation gap may diminish in the future.

14 Money shifted from Parmalat’s coffers to loss-making travel businesses controlled by the founder’s family. 15 Overestimation of oil reserves. 16 Underestimation of the accrual for gift certificates.

20

Appendix 1: Comparison SAS 99 – ISA 240: Risk factors relating to misstatements

arising from fraudulent financial reporting The following elements are examples of risk factors relating to misstatements arising from fraudulent financial reporting. They are taken from SAS 99 and ISA 240. We display both classifications: letters in SAS 99 and figures in ISA 240. The figures in italics have been added by the authors for a better reference to the examples in Appendix 3. There are two types of differences between the two standards: - Type 1: wording difference: “board of directors or audit committee” (SAS 99) vs. “those charged with

governance” (ISA 240); other wording difference: “reportable conditions” (SAS 99) vs. “material weaknesses in internal control” (ISA 240)

- Type 2: content difference: areas covered by ISA 240 but not by SAS 99.

SAS 99 ISA 240 Incentives/Pressures a./1. Financial stability or profitability is threatened by economic, industry, or entity operating conditions,

such as (or as indicated by) the following: 1.1 High degree of competition or market saturation, accompanied by declining margins. 1.2 High vulnerability to rapid changes, such as changes in technology, product obsolescence, or interest

rates. 1.3 Significant declines in customer demand and increasing business failures in either the industry or overall

economy. 1.4 Operating losses making the threat of bankruptcy, foreclosure, or hostile takeover imminent. 1.5 Recurring negative cash flows from operations or an inability to generate cash flows from operations

while reporting earnings and earnings growth. 1.6 Rapid growth or unusual profitability especially compared to that of other companies in the same

industry. 1.7 New accounting, statutory, or regulatory requirements. b./2. Excessive pressure exists for management to meet the requirements or expectations of third parties due

to the following: 2.1 Profitability or trend level expectations of investment analysts, institutional investors, significant

creditors, or other external parties (particularly expectations that are unduly aggressive or unrealistic), including expectations created by management in, for example, overly optimistic press releases or annual report messages.

2.2 Need to obtain additional debt or equity financing to stay competitive, including financing of major research and development or capital expenditures.

2.3 Marginal ability to meet exchange listing requirements or debt repayment or other debt covenant requirements.

2.4 Perceived or real adverse effects of reporting poor financial results on significant pending transactions, such as business combinations or contract awards.

c./3. Information available indicates that management or the board of directors’ personal financial situation is threatened by the entity’s financial performance arising from the following:

Information available indicates that the personal financial situation of management or those charged with governance is threatened by the entity’s financial performance arising from the following:

3.1 Significant financial interests in the entity. 3.2 Significant portions of their compensation (for example, bonuses, stock options, and earn-out

arrangements) being contingent upon achieving aggressive targets for stock price, operating results, financial position, or cash flow.

3.3 Personal guarantees of debts of the entity. d./4. There is excessive pressure on management or

operating personnel to meet financial targets set up by the board of directors or management, including sales or profitability incentive goals.

There is excessive pressure on management or operating personnel to meet financial targets established by those charged with governance, including sales or profitability incentive goals.

21

SAS 99 ISA 240 Opportunities a./1. The nature of the industry or the entity’s operations provides opportunities to engage in fraudulent

financial reporting that can arise from the following: 1.1 Significant related-party transactions not in the ordinary course of business or with related entities not

audited or audited by another firm. 1.2 A strong financial presence or ability to dominate a certain industry sector that allows the entity to

dictate terms or conditions to suppliers or customers that may result in inappropriate or non-arm’s length transactions.

1.3. Assets, liabilities, revenues, or expenses based on significant estimates that involve subjective judgments or uncertainties that are difficult to corroborate.

1.4 Significant, unusual, or highly complex transactions, especially those close to period end that pose difficult “substance over form” questions

1.5 Significant operations located or conducted across international borders in jurisdictions where differing business environments and cultures exist.

1.6 - Use of business intermediaries for which there appears to be no clear business justification.

1.7 Significant bank accounts or subsidiary or branch operations in [tax haven] jurisdictions for which there appears to be no clear business justification.

b./2. There is ineffective monitoring of management as a result of the following: 2.1 Domination of management by a single person or small group (in a non owner-managed business)

without compensating controls. 2.2 Ineffective board of directors or audit committee

oversight over the financial reporting process and internal control.

Ineffective oversight by those charged with governance over the financial reporting process and internal control.

c./3. There is a complex or unstable organizational structure, as evidenced by the following: 3.1 Difficulty in determining the organization or individuals that have controlling interest in the entity. 3.2 Overly complex organizational structure involving unusual legal entities or managerial lines of authority. 3.3 High turnover of senior management, legal

counsel, or board members. High turnover of senior management, legal counsel, or those charged with governance.

d./4. Internal control components are deficient as a result of the following: 4.1 Inadequate monitoring of controls, including automated controls and controls over interim financial

reporting (where external reporting is required). 4.2 High turnover rates or employment of ineffective accounting, internal audit, or information technology

staff. 4.3 Ineffective accounting and information systems,

including situations involving reportable conditions.

Ineffective accounting and information systems, including situations involving material weaknesses in internal control.

22

SAS 99 ISA 240 Attitudes/Rationalizations 1 Ineffective communication, implementation, support, or enforcement of the entity’s values or ethical

standards by management or the communication of inappropriate values or ethical standards. 2 Nonfinancial management’s excessive participation in or preoccupation with the selection of accounting

policies or the determination of significant estimates. 3 Known history of violations of securities laws or

other laws and regulations, or claims against the entity, its senior management, or board members alleging fraud or violations of laws and regulations.

Known history of violations of securities laws or other laws and regulations, or claims against the entity, its senior management, or those charged with governance alleging fraud or violations of laws and regulations.

4 Excessive interest by management in maintaining or increasing the entity’s stock price or earnings trend 5 A practice by management of committing to analysts, creditors, and other third parties to achieve

aggressive or unrealistic forecasts. 6 Management failing to correct known reportable

conditions on a timely basis.

Management failing to correct known material weaknesses in internal control on a timely basis.

7 An interest by management in employing inappropriate means to minimize reported earnings for tax-motivated reasons.

8 - Low morale among senior management. 9 - The owner-manager makes no distinction between

personal and business transactions. 10 - Dispute between shareholders in a closely held

entity. 11 Recurring attempts by management to justify marginal or inappropriate accounting on the basis of

materiality. 12 The relationship between management and the current or predecessor auditor is strained, as exhibited by

the following: 12.1 Frequent disputes with the current or predecessor auditor on accounting, auditing, or reporting matters. 12.2 Unreasonable demands on the auditor, such as unreasonable time constraints regarding the completion of

the audit or the issuance of the auditor’s report. 12.3 Formal or informal restrictions on the auditor that

inappropriately limit access to people or information or the ability to communicate effectively with the board of directors or audit committee.

Formal or informal restrictions on the auditor that inappropriately limit access to people or information or the ability to communicate effectively with those charged with governance.

12.4 Domineering management behavior in dealing with the auditor, especially involving attempts to influence the scope of the auditor’s work or the selection or continuance of personnel assigned to or consulted on the audit engagement.

23

24

Appendix 2: Press articles and SEC documents17 used for the case studies

Company When Number

scandal went

public Press articles SEC

documents Total

Adelphia Communications 2002 5 1 6 Ahold 2003 3 1 4 AIG 2005 4 1 5 AOL 2002 3 1 4 Bristol-Myers Squibb 2002 6 1 7 Cendant 1998 4 1 5 Computer Associates 2002 4 1 5 CMS Energy 2002 2 1 3 Datek Online 1998 3 1 4 Delphi 2004 4 1 5 Dollar General 2002 3 0 3 Duke Energy 2002 3 1 4 Dynegy 2002 3 1 4 El Paso Corporation 2002 4 1 5 Enron 2001 3 1 4 Freddie Mac 2003 6 1 7 Global crossing 2002 3 1 4 Halliburton 2002 4 2 6 Harken Energy 2002 4 0 4 HealthSouth 2002 5 1 6 Homestore.com 2002 3 2 5 HPL Technologies 2002 3 1 4 ImClone Systems 2002 4 1 5 K-Mart 2002 3 1 4 Lucent 2004 3 1 4 Merck 2002 3 0 3 MicroStrategy 2000 6 2 8 Network Associates 2000 2 1 3 Peregrine Systems 2002 4 1 5 Phar-Mor 1992 6 2 8 Qwest 2002 4 2 6 Reliant Energy 2002 2 2 4 Rite Aid Corporation 2002 4 1 5 Sunbeam 1998 5 1 6 Tyco 2002 3 2 5 Ullico 2002 4 0 4 Waste management 1999 2 2 4 WorldCom 2002 6 4 10 Xerox 2000 3 4 7 Total 146 49 195 Average 3.7 1.3 5.0 Standard deviation 1.2 0.8 1.5 Minimum 2 0 3 Maximum 6 4 10

17 SEC documents listed in this Appendix were not directly used to fill Appendix 3 but only to understand the technical and accounting aspects of the corporate fraud.

Appendix 3: Case studies of corporate scandals

This appendix presents a detailed analysis of the 39 corporate scandals. The components are classified according to the expectation gap analysis Level 1 components (Incentives-pressures (col. 1), opportunities (col. 2), attitudes/rationalizations (col. 3)); Level 2 components: deficient performance gap (col. 4); Level 3 components: deficient standards gap (col. 5) and “unreasonable expectations” (col. 6). A numbering system is used after each component to refer to SAS 99 and ISA 240 (see Appendix 1): In column 5, the underlined elements are covered by ISA 240 but not SAS 99. FFR stands for “Fraudulent Financial Reporting” while “MA” represents a “Misappropriation of Assets”. We mention after the company’s name the type of fraud. FFR is present in all the cases under study.

Auditing standards (fraud triangle) Deficient

performance gap

Deficient standards gap Unreasonable expectation gap

Level 1

Level 2 Level 3

# Companies Incentives/Pressures (1) Opportunities (2) Attitudes/

Rationalizations (3) Audit failure

(4) (5) (6)

1. Adelphia Communications (FFR – MA)

To meet Wall Street expectations (§ 2.1).

Family link (§ 2.1). To meet Wall Street expectations (§ 5).

Personal enrichment (§ 9). Sees himself as someone very generous and helpful. Money used to help people.

To maintain a high leaving standard, greed, “To have the funds to support his lifestyle”.

2. Ahold (FFR) Ambition for the group: to build an empire. Fixation on growth. Compete with Wal Mart (§ 1.1). Launched mergers => debts => to hide (§ 2.2) Stock options (§ 3.2)

Relationship with the distributors (§ 1.2).

Stock options (§ 4)

According to him, he acted for the good of the company, and the good of the Company was also his good.

Greed Company’s success and CEO’s personal success: reputation at stake Managers’ personality (“Mass market retailer of the year 2001”…)

3. AIG (American International Group) (FFR)

Pressure from the financial market which was criticizing the decline in AIG’s reserves (§ 2.1) Important shareholder and share price (§ 3.1) Stock options (§ 3.2)

Complex transactions (§ 1.4).

Stock options (§ 4) Obsessed by the daily fluctuations in the company’s stock price (§ 4)

Company’s success = CEO’s personal success - Reputation – Pride - “Imperial chief executive” - The market would lose faith in the company without him. Managers’ personality: tyrannical, nobody dared to oppose him.

25


performance gap


Level 1

Level 2 Level 3



(4) (5) (6)

4. AOL (FFR) Growth. To be able to buy the “giant” Time Warner (§ 1.1) Pressure of the financial market: considered advertising revenues as important to measure the performance (§ 2.1.) Share price (§ 3.1) Stock options (§ 3.2)

Use of estimates (§ 1.3)

Stock options (§ 4).

Chairman: Narcissist person.

5. Bristol-Myers Squibb (FFR)

To keep pace with rivals by reporting double-digit profit growth (§ 1.1) To meet internal sales and earnings targets and analysts’ earnings estimates (§ 2.1, 4) Share price (§ 3.1) Stock options, compensation bonus (§ 3.2)

“Channel stuffing” (sales to wholesalers) (1.2)

Stock options (§ 4)

Influence of the managers. Firm’s culture of “making the numbers”. Managers’ personality (youngest chief executive…) Lack of experience.

6. Cendant (FFR - MA)

To make the merger with HFS possible (§ 1.1). Stock options (§ 3.2).

Auditor located far away (§ 2.2). Manual accounting systems (§ 4.3).

Personal enrichment: payment of their living expenses (planes, golf). Too high living expenses (§ 9).

7. Computer associates (FFR)

Pressure to present strong growth figures (§ 2.1). Stock options (§ 3.2).

Domination of management by a small group (§ 2.1).

Personal enrichment with sale of stock options (§ 4).

Donation to and promotion of charitable causes. Built day-care centers for their children in CA offices

Awards received for the best managed company. “Software titan”.

26


performance gap


Level 1

Level 2 Level 3



(4) (5) (6)

8. CMS Energy (FFR)

Performance-based compensation, year-end bonus (§ 3.2). To be a credible marketer. Possible energy market manipulation. To follow Enron’s example.

“Round-trip” trades (§ 1.1).

High standard of living (expensive cars). Personal enrichment: boosting the revenues to increase year-end bonuses.

9. Datek Online (FFR)

Growth and creation of a group of companies.

Highly complex transactions (§§ 1.3, 1.4).

High standard of living (personal plane). “Technology wizard”. CEO appears in many rankings.

10. Delphi (FFR) To hide the bad financial state (§ 1). To fund pension obligations. To hide a dispute with General Motors To meet analyst earnings expectations (§ 2.1). Increase of stock price and sale of stocks (§ 3.1). Performance-based salary (stock options, incentives (§ 3.2).

Several executives involved (§ 2.1).

x (§ 2.2).

Greed (performance-based salary).

11. Dollar General (FFR)

Growth (§ 2.1). Stock options (§ 3.2).

Direct involvement of the CEO in preparing the company’s financial results (§ 2.1).

Donation to endow a program on moral leadership at a University.

Image of “marketing genius”.

27


performance gap


Level 1

Level 2 Level 3



(4) (5) (6)

12. Duke Energy (FFR)

Performance-based compensation, year-end bonus (§ 3.2)


Personal enrichment: manipulation to maximize the size of the year-end bonuses and other performance-based compensation

13. Dynegy (FFR) Salaries based on performance (§ 3.2).

“Round-trip” trades (§ 1.1). Close relationship between executives.

To be a leading global energy company.

14. El Paso Corporation (FFR)

Success and profitability. Top-rank of energy traders. Market power. To complete a merger. Ownership and increase of stock price (§ 3.1). Salaries based on performance (§ 3.2).


Personal enrichment (stock price § 4).

15. Enron (FFR - MA)

Growth. To enter the burgeoning deregulated energy markets without sacrificing the credit rating.

Personal relationship between executives.

x Personal enrichment: off-balance sheet partnerships (§ 9). Donation to the city’s art museum, fund-raiser for the local Holocaust Museum.

Influence of the CFO. CFO: Image of financial genius, arrogant, self confident. Threat towards analysts.

16. Freddie Mac (FFR)

To meet analysts’ expectations (reduction of earnings) - Appearance of sustained, predictable growth (§ 2.1). Stock options (§ 3.2).

Conflict of interest for the auditor (charity). Corporate culture which encourages fraud to approximate analysts’ forecasts.

Stock options (§ 4).

Donation to charities. Personnel ambition (to become the CEO).

28


performance gap


Level 1

Level 2 Level 3



(4) (5) (6)

17. Global crossing (FFR - MA)

Sustainability of the firm (§ 1). To meet securities analysts estimates (§ 2.1). Sale of shares (§ 3.1).

Swap of network capacity (§ 1.1, 1.2).

Personal enrichment: Consulting and real estate fees. Confusion between company’s assets and his own’s. (§ 9).

Greed, ambition: to build an empire (“the Emperor of Greed”. Personal enrichment: sale of shares when the business was going bad. Chairman is bright, aggressive and has a huge ego. “Roman emperor”.

18. Halliburton (FFR)

Bad state of the economy Sales of shares (§ 3.1).

Political link of the managers.

Stock options (§ 4): sale of stock options.

x

Greed

19. Harken Energy (FFR)

Sales of shares (§ 3.1). Political link of the managers

Insider trading.

Passion for sports (purchase of a football team).

20. HealthSouth (FFR)

Pressure from the market (§ 2.1). Sales of shares (§ 3.1). Salaries based on earnings (§ 3.2).

Lack of experience of certain mid-level executives. Involvement of many executives. Fake entries.

Donation to charities. Creation of a church.

Greed. Acquisition of planes, house and yacht. Wanted to be the “highest-paid CEO in the world”. CEO “terrorizing his colleagues and employees” (and analysts and journalists). Power and influence (network).

21. Homestore.com (FFR)

Revenue growth(advertising revenue) (§ 2.1). Contract with AOL Sale of shares (§ 3.1).

“Round-trip” transactions (§ 1.1). Fraud hidden to auditors.

Greed (sale of shares). CEO’s power, ambition (the CEO embodied the company).

22. HPL Technologies (FFR)

Growth in revenues. To be able to make an IPO. Collapsing markets of Silicon Valley and the world of high tech.

x The CEO funneled his own money to the company accounts in an attempt to cover fake sales.

Admired head of a fast-growing software company.

29


performance gap


Level 1

Level 2 Level 3



(4) (5) (6)

23. Im Clone Systems (FFR)

Sales of shares (insider trading) (§ 3.1).

Family link. Personal enrichment. Standard of living to maintain. To pay debts (secured by the stocks). Insider trading for himself and his family. Protect the wealth of his family and friends.

24. K-Mart (FFR - MA)

Competition with Wal-Mart (price war) (§ 1.1). Survival (weight of debts). Performance-based bonuses, stock options (§ 3.2).

Junior executives were demoted or transferred when they refused to make unrealistic forecasts.

Personal enrichment (personal air travel), loans to themselves. (§ 9).

25. Lucent (FFR) Internal sales target. External sales target (§ 2.1). Bonus on sales (§ 3.2). Keep their job

Deficient internal control.

Personal enrichment: bonuses on each sale they achieved. Career: So as to keep their jobs and/or to be promoted, by meeting the internal sales targets.

26. Merck (FFR) To make the Company look successful. Growth in revenues. To ease the IPO of a subsidiary.

No apparent personal interest.

x

27. MicroStrategy (FFR)

To boost the firm’s share price.

Total control of the company.

Personal problems (alcohol). CEO’s ego. Impressed by wealth.

30


performance gap


Level 1

Level 2 Level 3



(4) (5) (6)

28. Network Associates (FFR)

To become the world’s leading provider of network security products High growth rate targets (§ 2.1). Sale of stock options (§ 3.2). Performance based salary (§ 3.2).

Round-trip trades (§ 1.1).

Unreachable targets. (§ 5).

Career, image of competence. CEO bullying his employees (“suicide [is] sometimes an appropriate response to failure”).

29. Peregrine Systems (FFR - MA)

Peregrine’s success and viability in the short-run. Insider trading (sale of shares) (§ 3.1). Stock options (§ 3.2).

Family link (§ 2.1). Outside board member = brother-in-law of the chairman.

Personal enrichment (stock options) (§ 4).

x (the auditor

even encouraged the fraud).

Acquisition of golf membership (§ 9). Donation to charities.

30. Phar-Mor (FFR - MA)

To restore the Company’s profitability.

Very little oversight inside the company.

x Personal enrichment (home, jet, car…). (§ 9).

Influence of the CEO. CEO fascinated his co-executives (“god”). Passion for sports (funding of a basketball team).

31. Qwest (FFR) To meet earnings projections (§ 2.1). Double-digit growth (§ 2.1). Ambition: mergers needed Insider trading (sale of shares) (§ 3.1). Bonus based on the stock performance (§ 3.2).

Collusion between several top executives.

Passion for burgeoning sports and entertainment empire. Ambition, thirst of power. To build an empire Not to lose face.

31


performance gap


Level 1

Level 2 Level 3



(4) (5) (6)

32. Reliant Energy (FFR)

Ambition for the company: make the company one of the best energy traders. Enron’s influence (energy market).

Round-trip trades (§ 1.1). New field, new market (no one knew what the size of the market).

Executive’s career and image of competence.

33. Rite Aid Corporation (FFR)

To do better than his father. => mergers => high debt. Rite Aid as a powerful retail company. Sale of shares (§ 3.1). Salaries based on performance (§ 3.2).

Family link (§ 2.1). High standard living (helicopter). Real estate transaction with the family. Ambition and competence. Martin Grass was bullying his employees and partners

34. Sunbeam (FFR)

Growth in earnings (§ 2.1). Sale of shares (§ 3.1).

x Worldwide reputation, recognition CEO considered as a miracle worker, a genius by the business world. Tyrannical CEO.

35. Tyco (FFR - MA)

Ambition: image of a growth company. Many (expensive) acquisitions Unauthorized bonuses.

x Personal enrichment (use of loans for luxury apartments, yachts, jewelry, parties) (§ 9).

Greed

36. Ullico (FFR) Stock options (insider trading) (§ 3.1).

Many executives and directors involved.

Personal enrichment with sale of shares.

37. Waste Management (FFR)

Earnings target (§ 2.1). Stock options (§ 3.1). Bonus based on performance (§ 3.2).

x Professional career.

32

33


performance gap


Level 1

Level 2 Level 3



(4) (5) (6)

38. WorldCom (FFR)

Company’s performance (§ 2.1). Ever growing revenue and income (§ 2.1). To meet analysts’ forecast (§ 2.1). To maintain the share price.

Management hides the truth.

Personal enrichment (shares of the company) (§ 4).

Donation to charities. Fund raising for the local college. Scholarships, free telephone service for hurricane victims.

Complicity between the CEO and the CFO. Autocratic boss.

39. Xerox (FFR) Earnings target (§ 2.1). To boost the firm’s share price Increase in compensation (including stock options) (§ 3.1, 3.2).

Opposition within the board.

Personal enrichment (shares of the company) (§ 4).

x

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37

Figure 1: Expectation gap and fraud

Adapted and developed from Porter (1993)

Unreasonable expectations

Deficient standards

Attitudes / Rationalizations

Opportunities Incentives

Fraud triangle Performance gap Reasonabless gap

Deficient performance

Perceived performance of auditors

Society’s expectations of auditors

Auditor failure

Rationalizations Differences with

ISA 240

Auditor fraud detection Audit expectation-performance gap

Public opinion (through the press)

38

TABLE 1

Explanation of fraud behaviors present in the auditing standards (fraud triangle) Elements of the fraud triangle

Items Companies involved (anecdotal evidence)

Incentives/ pressures

High degree of competition or market saturation

Ahold, AOL, Bristol-Myers Squibb, Cendant, HPL Technologies, K-Mart, Reliant Energy

Profitability or trend level expectations of investment analysts, institutional investors, significant creditors or other external parties

Adelphia Communications, AIG, AOL, Bristol-Myers Squibb, Computer Associates, Delphi, Dollar General, Freddie Mac, Global Crossing, HealthSouth, Homestore.com, Lucent, Merck, MicroStrategy, Network Associates, Phar-Mor, Qwest, Sunbeam, Waste Management, WorldCom, Xerox

Need to obtain debt or equity financing to stay competitive

Ahold, Datek Online, Enron, HPL Technologies, K-Mart, Merck, Rite Aid Corporation, Tyco

Significant financial interests in the entity

AIG, AOL, Bristol-Myers Squibb, Delphi, El Paso Corporation, Global Crossing, Halliburton, Harken Energy, HealthSouth, Homestore.com, Im Clone Systems, Peregrine Systems, Qwest, Rite Aid Corporation, Sunbeam, Ullico, Waste Management, Xerox

Significant portion of the compensation being contingent upon achieving aggressive targets for stock price operating results, financial position of cash flow

Ahold, AIG, AOL, Bristol-Myers Squibb, Cendant, Computer Associates, CMS Energy, Delphi, Dollar General, Duke Energy, Dynegy, El Paso Corporation, Freddie Mac, HealthSouth, K-Mart, Lucent, Network Associates, Peregrine Systems, Qwest, Rite Aid Corporation, Waste Management, Xerox

Opportunities Significant related-party transactions not in the ordinary course of business

CMS Energy, Duke Energy, Dynegy, El Paso Corporation, Global Crossing, Homestore.com, Network Associates, Reliant Energy

Strong financial presence or ability to dominate an industry

Ahold, Bristol-Myers Squibb, Global Crossing

Accounting figures based on significant estimates

AOL, Datek Online

Significant, unusual, or highly complex transactions

AIG, Datek Online

Domination of management by a single person or small group

Adelphia Communications, Computer Associates, Delphi, Dollar General, Enron, HealthSouth, Im Clone Systems, K-Mart, MicroStrategy, Peregrine Systems, Qwest, Rite Aid Corporation, Ullico

Ineffective board of directors or audit committee oversight over the financial reporting process and internal control

Cendant, Delphi, Enron, Halliburton, HPL Technologies, Merck, Peregrine Systems, Phar-Mor, Sunbeam, Tyco, Waste Management, WorldCom, Xerox

Ineffective accounting and information systems

Cendant, Lucent

Attitudes/ rationalizations

Excessive interest by management in maintaining or increasing the entity’s stock price or earnings trend

Ahold, AIG, AOL, Bristol-Myers Squibb, Computer Associates, El Paso Corporation, Freddie Mac, Halliburton, Peregrine Systems, WorldCom

A practice by management of committing to analysts, creditors, and other third parties to achieve aggressive or unrealistic forecasts

Adelphia Communications, Network Associates

The owner-manager makes no distinction between personal and business transactions

Adelphia Communications, Cendant, Enron, Global Crossing, K-Mart, Peregrine Systems, Phar-Mor, Tyco

39

TABLE 2 Deficient standards gap Panel A - Rationalizations

Items Companies involved (anecdotal evidence) Charitable causes Adelphia Communications, Computer

Associates, Enron, Freddie Mac, HealthSouth, and WorldCom

Action for the good of the company Ahold Panel B – Difference SAS 99 – ISA 240

Items Companies involved (anecdotal evidence) Personal enrichment Adelphia, Cendant, Enron, Global Crossing, K-

Mart, Peregrine Systems, Phar Mor, Tyco

40

41

TABLE 3 Unreasonable expectations

Categories Items Companies involved (anecdotal evidence) Living standard To maintain a high living standard Adelphia Communications, Cendant,

Computer Associates, Datek Online, HealthSouth, Im Clone Systems, Phar-Mor, Rite Aid Corporation, Tyco

sometimes linked to a passion for sports

Harken Energy, Qwest

Reputation Reputation at stake (company’s success = personal success)

Ahold, AIG, Network Associates, Qwest

Influence Influence of the managers Bristol-Myers Squibb Influence of the CEO Enron, Phar-Mor Complicity between the CEO and the

CFO WorldCom

Prize Prize received Ahold, Computer Associates or superlative: - Youngest chief executive (Bristol-

Myers Squibb) - Marketing genius (Dollar General) - Admired head of a fast-growing

company, very rich and very young manager (Datek Online)

- Highest-paid CEO (HealthSouth) - Worldwide recognition (Sunbeam) - Financial wizard (CFO of WorldCom)

Personality Personality - Tyrannical/autocratic (AIG, Enron, HealthSouth, Network Associates, Rite Aid Corporation, Sunbeam, WorldCom)

- Narcissistic (AOL) - Encourages hero worship of executives

(Phar-Mor) - Personal ambition - career (Freddie

Mac, Homestore.com, Reliant Energy, Waste Management) or for the firm (Global Crossing, Qwest)

- Alcoholic (MicroStrategy)

eg and corporate fraud: is public opinion reconcilable ... · expectation gap and corporate fraud:...

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