M. Agostini and G. Favero

Accounting fraud, business failure and creative auditing: A micro-analysis of the strange case of Sunbeam Corp.

Working Paper n. 12/2012Revised: March 2013

ISSN: 2239-2734

This Working Paper is published   under the auspices of the Department of Management at Università Ca’ Foscari Venezia. Opinions expressed herein are those of the authors and not those of the Department or the University. The Working Paper series is designed to divulge preliminary or incomplete work, circulated to favour discussion and comments. Citation of this paper should consider its provisional nature.

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Accounting Fraud, Business Failure and Creative Auditing: A Micro-Analysis of the Strange Case of Sunbeam Corp.

Marisa Agostini,

Ca’ Foscari University of Venice,

Department of Management, San Giobbe

Cannaregio 873, 30121 Venice, Italy.

E-mail: marisa.agostini@unive.it

Tel. (+39) 041 2348732

Fax (+39) 041 2348701

Giovanni Favero,

Ca’ Foscari University of Venice,

Department of Management, San Giobbe

Cannaregio 873, 30121 Venice, Italy.

E-mail: gfavero@unive.it

Tel. (+39) 041 2348732

Fax (+39) 041 2348701

(March 2013)

Abstract

This paper puts under a magnifying glass the path to failure of Sunbeam Corp. and emphasizes the

reasons for its singularity and exceptionality. This corporate case emerges as an outlier from the

analysis of the US fraud cases mentioned by WebBRD: the consideration of the time between fraud

disclosure and the final bankruptcy reveals that the value of this temporal variable is estimated

equal to 840 days in the case of Sunbeam, really far from the range estimated by the survival

function for the entire sample. Different hypotheses explaining this exceptionality are evaluated in

the paper, starting from the consideration of the peculiarities of Sunbeam’s history: fraud duration,

scapegoating and creative auditing represent the three main points of analysis. Taking to heart the

fact itself that the case under examination is an outlier, we perform a micro-analysis of this case that

the SEC investigated in depth and this work describes in detail, providing unexpected insights and

inputs for future research concerning auditing and accounting fraud.

Keywords: accounting fraud, failure path, creative auditing, historical micro-analysis

JEL Classification Numbers: M41, M42, N80, N82, M48

Acknowledgements. Earlier versions of this paper were circulated under the title “A comparison

between different business paths through failure” at the 6th EBHA Doctoral Summer School

“Business History: Debates, Challenges And Opportunities” (Terni, 27th August 2011 - 1st

September 2011). Moreover, this work was presented (after full paper submission) at the

International Accounting and Auditing Conference (Amsterdam, 20th - 21st June 2012).

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1) INTRODUCTION

 

Unlike traditional literature, which is focused on reaching a substantial agreement over the

most suitable methodology for predicting final business failure (Beaver, 1968; Altman, 1968), more

recent pieces of research emphasize the relationship between time dimension, failure stages and

accounting information (Hill, Perry & Andes, 1996; Cybinski, 2001). This paper aims to be part of

this second stream of research, whose importance has been repeatedly emphasized in the last few

years. In particular, Humphrey (2008) reviews audit research and questions the relevance of

quantitative modelling studies to auditors, auditees, professional accounting associations and

corporate regulatory authorities both before and after the lesson of famous corporate scandals (e.g.

Enron and WorldCom). The need for detailed qualitative contextual research on these crashes is

highlighted in other authoritative literature (Lee, 2004; Humphrey, 2005; Parker, 2005): the lack of

specific and precise knowledge implied in fact that in the Enron case, for instance, fraud and its

consequences came “as a surprise”. These considerations represent the premise of the present paper,

which aims to implement what Parker (2012, p. 67) observes: “The qualitative agenda has much to

offer in unpacking these processes of accounting, auditing and accountability, and in addition

translating qualitative management accounting issues and research designs into the financial

accounting and auditing arenas, as well as bringing questions of internal management and

accounting control systems in large scale corporate crash experiences under the microscope.” On

the other hand, Armstrong (2008) among others have stressed the need for qualitative studies to

cope with the problem of the idiosyncratic significance of ethnographic case studies.

For these reasons, starting from a previous study (Agostini, 2012), demonstrating that fraud

disclosure usually takes firms to bankruptcy very fast, this paper analyses in detail an exception to

this statistical rule. The usefulness of considering “deviant cases” is emphasized in the theoretical

debate on path dependency, to which the present paper also makes reference for the analysis of the

business failure path: the “deviant cases” follow a peculiar path-dependent logic where early

contingent events set cases on an historical trajectory of change that diverges from theoretical

expectations (Emigh, 1997; Mahoney, 2000). Path dependence, however, is only one of the possible

approaches to exceptional cases. A specific methodology, useful to deal with the idiosyncratic

nature of exceptional cases in order to logically extract from their analysis new theoretical

hypotheses, was developed in the historical disciplines some decades ago in the context of the

debate on micro-history (Trivellato, 2011), which then spread to accounting history (Williams,

1999). The starting point for a micro-analytical approach is the critical comparison of all available

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sources: in our case, annual reports with obvious caveats, business columns, published interviews,

and the results of the US Securities and Exchange Commission (SEC) investigation. This is coupled

with the effort to avoid simplification, “not to sacrifice knowledge of individual elements to wider

generalization”: in fact, when dealing with historical reality, where the experimental “ability to

reproduce the causes is excluded, even the smallest dissonances prove to be indicators of meaning

which can potentially assume general dimensions” (Levi, 1992, p. 109). In this perspective, the

interpretation of an extraordinary case, such as the outlier here taken into consideration, can indeed

shed light on broader trends and possibly falsify general assumptions about what is possible or not.

In this paper, we take this idea to heart and try to develop it, starting from the proper statistical

identification of our exceptional case as an outlier.

In fact, the presence of the outlier, here considered, emerges from the analysis (TABLE 1) of

the time between the fraud disclosure date and the date of bankruptcy (i.e. the TIME2 variable, as

defined in Agostini, 2012) in the US fraud cases mentioned by WebBRD1. Overall, the survival

function estimates about a 25% chance of falling into bankruptcy within 53 days after the fraud

disclosure date, 50% within 99 days and 75% within 215 days. Considering some descriptive

statistics, the maximum value of the TIME2 variable is estimated equal to 840 days: this is really far

from the range estimated by the survival function and it refers to Sunbeam Corp. (Fig.1).

 

TABLE 1 – TIME2 variable analysis

In this table (TABLE 1), as in the following figure (Fig. 1), the number-label “27” identifies the

                                                            1 The sampled firms are included in the WebBRD (Bankruptcy Research Database) which contains data on all large, public company bankruptcy cases filed in the United States Bankruptcy Courts from October 1, 1979 through March 1, 2010. The sample selection is made according to the cause of bankruptcy (i.e. fraud) and the type of activity (i.e. different from finance, insurance, and real estate). 

time2 1 840 . 840 840 Variable Obs Mean Std. Dev. Min Max

. sum time2 if id==27

time2 30 154.8667 178.4815 0 840 Variable Obs Mean Std. Dev. Min Max

. sum time2

total 840 .0011905 1 . . . time at risk rate subjects 25% 50% 75% incidence no. of Survival time

analysis time _t: time2 failure _d: status

. stsum if id==27

total 4646 .0062419 29 53 99 215 time at risk rate subjects 25% 50% 75% incidence no. of Survival time

analysis time _t: time2 failure _d: status

. stsum

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sample case of Sunbeam Corp: the survival function reveals that this company took 840 days (i.e. the maximum number of days for the sample) to fall into bankruptcy after the fraud disclosure.

Fig.1 - One outlier from TIME2 variable analysis

In this chart (Fig. 1), as in the previous table (TABLE 1), the number-label “27” identifies the sample case of Sunbeam Corp: the survival function reveals that this company took 840 days (i.e. the maximum number of days for the sample) to fall into bankruptcy after the fraud disclosure.

Given the exceptionality of the case, both from a descriptive-statistical point of view and in

the light of the existing literature on the determinants and characteristics of accounting fraud, the

present work focuses on an in-depth study of Sunbeam’s path to failure. It aims to explain the

reasons for its uniqueness in order to derive from this micro-analysis new questions and

considerations concerning accounting fraud and bankruptcy. A correct approach to this methods

requires us to define our research questions by asking at first what the micro-analysis of this single

case (selected as an outlier in the statistical distribution described above) can show us about the

mechanisms relating to accounting fraud and business failure. This matter requires an articulated

answer that we have translated into the multiple operational research questions listed below.

Firstly, the micro-analysis of a single case can shed light on causal mechanisms which are

too complex to emerge from standard empirical studies based on statistical approaches. A coherent

research strategy in this case is to ask how the specific fraudulent strategy of performance

overstatement adopted in the Sunbeam case can be connected to the peculiar modality of its

disclosure, making it possible to scapegoat the CEO, to (temporarily) discharge the board and the

company of any responsibility, and to pursue a business recovery.

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Secondly, the exceptional features characterizing the case can suggest (by contrast) new

hypotheses about what are the usual mechanisms at work, explaining the reasons for the

concentration around average values of the statistical variables considered. The related operational

research question will be about the factors (not existing in other cases) which may explain

Sunbeam’s exceptionally long time to macro-failure (in this case, bankruptcy).

However, the outlier can sometimes represent the “tip of the iceberg” of not measurable

phenomena (as, for instance, cases of undetected fraud). Consequently, the paper investigates what

made possible for Sunbeam’s fraud to be discovered and in what measure the exceptional factors

explaining the odd behaviour of Sunbeam could be interpreted as usually invisible.

Finally, the outlier can be the signal (i.e. the visible sign or red flag) of a dynamic evolution

that explains its emergence as the result of a “blind evolutionary path”. In this case, the operational

research question takes a counter-factual aspect: what could have made this case unexceptional, or

what could have made it possible to generalize some of its specific features?

Different hypotheses will consequently be analysed in the following sections, starting from

the consideration of the peculiarities of Sunbeam’s history. The paper is organized as follows. The

following section reviews the relevant literature about the factors characterizing Sunbeam’s fraud

process: fraud duration, scapegoating and creative auditing. The third section analyses the presence

and the relevance of these factors in the concrete case under examination. Section four illustrates

the relationship among these variables, providing answers to the above questions and highlighting

the contribution of this paper to the literature. Lastly, some concluding remarks summarizing the

paper are presented.

2) REVIEW OF THE THEORETICAL LITERATURE

2.1 Determinants of fraud, time to disclosure and time to bankruptcy.

As the starting problem of this paper is the exceptionally long time from fraud disclosure to

bankruptcy in the case of Sunbeam Corp., most of the existing literature focusing on the

determinants of fraud and its duration (time to disclosure) seems off target. However, the micro-

analytical approach, adopted here, provides the opportunity to make reference to a wide set of

literature about different aspects of the theoretical debate, in order to allow an overall understanding

of its complex evolutionary path, going from fraud to disclosure and then to macro-failure (i.e.

bankruptcy).

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Generally speaking, the literature, considered below, starts from the empirical analysis of

statistical correlations at aggregate level between fraud dynamics and other variables concerning the

firm (endogenous) or its environment (exogenous) to infer some explanatory models: these

contributions are very useful in order to build up a repertoire of models to be tested on the case, but

also to correctly define the relevant context and the pertinent issues (Jones, 2011).

In this respect, it should be first recalled that this work deals with a specific kind of fraud,

related to financial misstatement. This typology represents a small minority (4.8 %) of the number

of frauds occurring at global level in 2009, following a survey of the Association of Certified Fraud

Examiners (ACFE, 2010); however, it still made up the absolute majority (68 %) of reported losses,

with a median loss of $ 4,100,000 ($ 1,730,000 considering only frauds committed in the United

States) against $ 160,000 for all kinds of occupational fraud;2 perhaps more interestingly here, it

also took the longest to be discovered, with a median duration of 27 months, as against 18 months

for all frauds (ACFE, 2010, pp. 10-14). More specifically, a further distinction between two main

typologies of accounting fraud can be pointed out considering different systems of corporate

governance (Jones, 2011): an excess of power retained by entrepreneurs or managers is usually at

the origin of misstatement crimes in continental (European) financial systems, whereas in the

United States (as in most of the Anglo-Saxon countries) accounting fraud seems mainly to result

from the pressure on performance exerted by financial investors, market analysts and internal

budgeting on top and middle managers. If the latter is assumed to represent the set of pertinent

circumstances in our case, the search for private benefit would be only the indirect result of a

managerial conduct aimed, above all, at meeting the expected results. In the Sunbeam case, as

discussed below, responsibility for the fraud was mainly attached to the company’s CEO,

emphasizing his managerial style as directly connected to the resulting misstatement.

Moreover, the models proposed by the literature to explain the motivations for fraudulent

overstatement of company financial performances usually apply an opportunity-cost framework

with contrasting results related to the considered system of incentives. For instance, the non-linear

correlation between the number of frauds committed and the expected aggregate economic

performance (i.e. optimism) is explained making reference to different mechanisms (Davidson,

2011). A first explanation takes into consideration the changing performance threshold according to

which investors decide whether to monitor in depth the state of a firm or rely on public information

                                                            2 ACFE (2010) defines occupational fraud as the “use of one’s occupation for personal enrichment through the deliberate misuse or misappropriation of the employing organization’s resources or assets” (p. 2). 

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about it: this implies consequent changes in managers’ cost opportunity about the performance

overstatement (Povel, Singh & Winton, 2007). Another explanation considers instead the varying

ability of analysts to effectively predict aggregate trends as affecting the number of firms

performing less than expected, pushing their managers to overstate performances in order to keep

up with their competitors on the job market (Fernandes & Guedes, 2009).

It is also worth signalling the existence of endogenous explanations of the cyclical trend of

fraud, making reference to a circular predator-prey model (Volterra, 1928) and using the number of

scammers (and the lagged number of victims) as the dependent (or independent) variable affected

by (or affecting) the return to fraud (or to vigilance), in its turn (Gong, McAfee & Williams, 2011)

affected by (or affecting) the level of vigilance (fraud). However, this kind of approach does not

consider that accounting fraud is a special case of the classical deterrence hypothesis (Becker, 1968)

because of the presence of a “linkage” problem: this implies for the budget manipulator a higher

probability of being discovered should the fraud cease (Baer, 2008). Higher sanctions increase then

the opportunity cost of stopping manipulation, generally increasing also the time to disclosure,

pushing managers to resort to lobbying (Yu & Yu, 2011) or M&A (Erickson, Heitzman & Zhang,

2011) as a means to postpone or possibly avoid fraud disclosure.

Acquisition is particularly interesting in the analysis of the case considered in this study

because it was adopted as a strategy to conceal fraud only after an attempt to sell the company

itself. Looking at the issue from this perspective, it is interesting to consider (Baer, 2008) what can

lead manipulators to stop their conduct if not yet discovered: shifting the blame to other people may

represent one of the few conditions leading the manipulator to leave the game, but it is very difficult

to investigate such problems, as far as undetected frauds are concerned. For instance, Summers and

Sweeney (1998) tried to control for undetected frauds by screening the litigation history of their

sample, but their method implies the assumption that sooner or later any fraud will be detected. In a

more recent paper, Wang (2011) proposes the use of an econometric model in order to separate out

from the probability of fraud the two component probabilities of committing and detecting fraud:

her analysis shows how such components can be affected by different variables and how they can

interact. In particular, she suggests that acquisitions are correlated to fraud because of the high

visibility of these transactions, despite the fact that active acquirers are actually less likely to

commit fraud than the average, as they are more likely to be discovered. The correlation between

the presence of investments implying higher volatility in their results and a higher probability of

producing financial misstatements is also very interesting because in this cases fraud detection is

less likely: the “veil” created by business uncertainty can foster fraudulent behaviour by exposing

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companies to both more frequent performance shocks and higher financial needs, but also allowing

managers to appeal to volatility as a justification for any alteration in expected or assessed

performances.

The focus on the mechanisms of governance and fraud deterrence has been criticized in the

literature as not taking into account the role of executives’ personal features such as overconfidence

in their choices and the imperative to “correct” poor performances that could threaten their jobs

(Schrand & Zechman, 2011). This kind of argument is particularly relevant in the case under

scrutiny, given the renowned aggressive managerial style of Al Dunlap, the CEO who was chief of

Sunbeam during the fraud period: the CEO’s personal conduct emerges as a first peculiar

characteristic of the case, influencing its exceptionality.

The importance of personal attitudes appears significant also in relation with the differential

effects on market performances that were observed where management integrity was concerned, in

comparison with those connected to technical accounting issues (Palmrose, Richardson & Scholz,

2004). As shown below, one argument put forward by the fired CEO after the Sunbeam fraud

disclosure was precisely that concerning the technical nature of the misstatement, in an unsuccessful

attempt to avoid being made the sole guilty party in the fraud.

However, what is more interesting in this case is the “survival strategy” adopted by the

company immediately after the fraud disclosure. This strategy, following the analysis proposed by

Sutton and Callahan (1987), could be identified as a mix of denying and (partially) accepting

responsibility for the fraud, resulting in the immediate dismissal and scapegoating of the CEO, who

was finally banned from serving as an officer or a director of a public company. This outcome is

indeed exceptional if compared with the usual effects of the disclosure of accounting fraud on

fraudulent managers, for whom it is usually very unlikely to receive legal sanctions (Velikonja,

2011), but who suffer from negative effects on their reputation (Karpoff, Lee & Martin, 2008).

2.2 Managerial scapegoating and creative auditing.

The fact that the CEO alone was scapegoated for the emerging fraud represents another

instance of the exceptionality of the case. As the auditing literature shows clearly, auditors are in

fact usually scapegoated after fraud disclosure: in the case of Sunbeam Corp. there was a shift from

the auditors to the CEO of the scapegoat function, as we will discuss in detail below.

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It is important to emphasize the inherent ambiguity of the scapegoat role: in the case of

Sunbeam Corp., the CEO himself was first identified as the major intangible asset of the company

and then as the major threat to its survival. According to René Girard (1972; 2005), indeed, the all-

against-all struggle characterizing a crisis turns into a fight of all against one (i.e. the scapegoat)

who comes to be seen as the only party responsible for the turmoil through a process of

mythification. Terrified and angry, the actors want to identify the cause of the crisis. Naturally,

rather than blaming themselves, they are inclined to suspect others: mutual distrust and accusations

spread throughout the entire group. The selection of the surrogate victim is rarely totally random. In

most cases, the chosen scapegoat possesses certain victimizing signs, i.e. signs making him an actor

somehow departing from normality within the group. The focus on the auditing function (Guénin-

Paracini & Gendron, 2010) as warranting the credibility of capital markets, even becoming the

sacrificial victims of corporate scandals, is perfectly justified where the general evolution of fraud

cases and legislative measures in the last few decades is concerned, as shown in the following

paragraphs.

However, this was not the case of Sunbeam, where the auditors’ peculiar behaviour and

work made it possible to recognize the scapegoat in the CEO: he was rapidly fired in order to help

the company recover. We cannot avoid noticing that this reversal in the CEO’s reputation was

mirrored by a parallel boom and bust of Sunbeam’s share value, which followed the typical trend of

speculative bubbles. It is from this point of view that Girard’s (1978; 1987) first explanation about

the origin of the scapegoating mechanism turns out to have more than expected to tell us about the

relation between accounting fraud and business failure. In fact, in Girard’s archetypal story, it is the

mimesis (imitation) mechanism that explains the desire to possess things that others possess, the

struggle of all against all and the identification of a scapegoat to be sacrificed, in a progressive shift

of the same focus of imitation from the act of appropriation to the object of appropriation (mimetic

desire), and from the act of fighting (generalized conflict) to the object of fighting (the scapegoat as

everybody’s enemy). In this perspective, it is worth recalling that imitation is also the main

mechanism explaining speculative bubbles: investors imitate other investors creating waves of

optimism and pessimism that explain volatility (Corcos, Eckmann, Malaspinas, Malevergne &

Sornette, 2002). This imitation mechanism can also explain the abrupt change in the value the

market assigned to the CEO of Sunbeam Corp., transforming him from a major asset into a major

threat for the company and making him into a perfect scapegoat in order to exit from a difficult

situation. It is then possible to say that in this case market trends clearly reproduced the logics

behind Girard’s scapegoating mechanism.

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On the other hand, we should recall that in the Sunbeam case the auditors were able to

escape their fate as privileged scapegoats by means of their peculiar behaviour, which is worth

analysing in more depth as its interpretation requires the introduction of a new theoretical concept,

i.e. the category of “creative auditing”. Let us explain this in detail.

After famous accounting scandals occurred and influenced the world economy, the concept

of creative accounting has emerged as a set of legal and illegal aspects due to the flexibility of

accounting policy. Several definitions of it have been provided. Omurgonulsen and Omurgonulsen

(2009) summarize them: creative accounting represents both a process whereby managers use their

knowledge of accounting rules to manipulate the figures reported in the accounts of a business and a

set of undesirable practices which prevent people seeing the true and fair financial state of a

company. Managers prefer to use creative accounting practices to manipulate profit to tie into

forecasts and to distract attention from the news, which would not be welcome. Thus, creative

accounting can be framed and related to the “agency theory” (Amat, Blake & Dowds, 1998): the

information asymmetry between principals (owners or shareholders) and agents (managers), the

opportunistic behavior of agents and the inability of principals to control the desired action of

agents provide a theoretical framework to understand such cases (Arnold & de Lange, 2004). The

framework of the “principal–agent relationship” emphasizes also one of the most frequent possible

causes of creative accounting: this practice sometimes occurs due to pressure from top management

(Leib, 2002). In any case, the first and most relevant feature of creative accounting is represented by

its legacy: it is totally legitimate (Griffiths, 1986). Starting from this consideration, the concept of

creative accounting has been isolated from other practices. In fact, an important differentiation

(Jones, 2011) must be made between a fair presentation, where the flexibility within accounting is

used to give a true and fair picture of the accounts so that they serve the interests of users; creative

accounting, where the flexibility within accounting is used to manage the measurement and

presentation of the accounts so that they serve the interests of preparers; and fraud, which consists

in deliberately stepping outside the regulatory framework to give a false picture of the accounts. In

this perspective, only the latter represents fraudulent financial reporting, which has been defined as

“an intentional misstatement of financial statements” (Arens, Beasley & Elder, 2003): the three

practices (i.e. not-tort, creative accounting and fraud) represent three possible different levels of use

and misuse of accounting by managers.

The same distinction among different practices has not yet been introduced in the literature

for the auditing process. In the literature on fraud detection, accounting and auditing have indeed

followed different paths. However, even though they are separated from a temporal point of view,

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they are quite similar with regard to other aspects. In fact, a fruitful area of prior research has been

related to the tools and techniques to improve fraud detection such as ratio analysis, checklists,

analytical procedures, regression analysis, digital analysis, and neural networks, which were applied

first to the accounting and then to the auditing process (Hogan, Rezaee, Riley & Velury, 2008).

Moreover, there is a significant amount of literature on the causes and features of fraud processes:

pressures to meet analysts’ forecasts, rapid growth, compensation incentives, stock options, the need

for financing, and poor performances all increase the likelihood of fraudulent financial reporting

(Bell & Carcello, 2000; Rezaee, 2005; Erickson, Hanlon & Maydew, 2006). The correct and

incorrect accounting practices (i.e. not-tort, creative accounting and fraud) implemented by

managers for such reasons may find a correspondence in the practices used by auditors, with the

same escalation from good to bad methods. However, those categories have not been used to

interpret the auditing process in the main streams of literature that deal with it: let us briefly analyse

this literature.

First, several contributions start from the point that external auditors both may and should

play a role in reducing the opportunities to manipulate earnings or commit fraud (Becker, Defond,

Jiambalvo & Subramanyam, 1998; Francis & Krishnan, 1999; Iyer & Rama, 2004; Myers, Myers &

Omer, 2003; Carcello & Nagy, 2004). This is related to the definition of auditing itself (Arens et al.,

2003), which is “a systematic process of objectively obtaining and evaluating evidence regarding

assertions about economic actions and events to ascertain the degree of correspondence between

those assertions and established criteria and communicating the results to interested users”

(American Accounting Association, 1973). According to this definition, several authors emphasize

the importance of auditing in implementing fraud detection. Chen, Kelly and Salterio (2012)

examine whether different audit procedures and attitudes conveyed to management are useful to

deter aggressive earnings misstatement that may be fraudulent, and whether such different

procedures and attitudes have an influence on managers’ perceptions about the ethicality of any

earnings manipulation. So, audits are claimed not only to enhance the detection of fraud but also its

deterrence or prevention (US Treasury Department, 2008). The longstanding claim about financial

auditing as a fraud deterrence mechanism (Mautz & Sharaf, 1961; Wells, 2004) is based more on

logical reasoning than on empirical evidence (Schneider & Wilner, 1990): management reports

more honestly because its actions will be audited (Baiman, Evans & Noel, 1987). Fraud deterrence

should logically increase when managers perceive that an audit increases the probability of

detection, whether or not the detection probability actually increases (Decker, 2003; Scheider,

2001): they know that any perpetuated fraud has a higher chance of being discovered with auditing.

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In more detail, the theory of deterrence (Chen et al., 2012) proposes three factors that affect

people’s judgments about engaging in illegal or undesirable activities, i.e. the certainty, severity, and

swiftness of punishment. When people perceive an increase in the certainty of being caught in an

illegal or socially undesirable act that results in severe and quick punishment, the cost of

committing the act increases, reducing the act’s expected utility and the likelihood that people will

commit the act in the first place: according to the deterrence theory, managers would be deterred

from potentially fraudulent activities if they perceive an increased probability of punishment when

they observe changes in auditors’ actions and activities. Moreover, detection and deterrence are

intimately interwoven, as an increase in the detection ability of the auditor, if it becomes widely

known, should also lead to an increase in the deterrence ability of an audit. In this role, auditors’

activity has been supported also by standard-setters. In fact, in an attempt to prevent fraud, the

Auditing Standards Board (2002) issued the Statement on auditing standards 99 (SAS 99), which

introduced a “fraud triangle”. The fraud triangle indicates that the probability of committing fraud is

higher in situations where a) management or other employees have incentives to fraud or are under

financial pressure, b) there exist conditions that provide opportunities for management or

employees to commit fraud, and c) there exist ethical values or characteristics that cause

management or employees to rationalize the fraudulent act. Peecher, Schwartz, and Solomon (2007)

advocate that auditors triangulate audit evidence from both internal and external sources to identify

inconsistencies that could improve the auditor’s ability to detect intentional misstatements.

On the other hand, some studies have emphasized that external auditors may be involved in

managers’ fraud plans. This has been related to a decrease in the quality of the audit: the value of

external audits derives from users’ expectations that auditors will detect and reveal any material

omissions or misstatements of financial information. In fact, the audit “quality” is defined in terms

of the level of assurances, i.e. the probability that financial statements contain no material omissions

or misstatements. This definition is consistent with both DeAngelo’s (1981) definition of audit

quality and with the professional literature that defines audit quality in terms of audit risk, with

higher quality services reflecting lower audit risk. Raiborn and Schorg (2004) describe the growing

distrust in the auditing profession as “a cancer that is metastasizing” because of famous scandals:

for instance, Arthur Andersen, the external auditor of Enron, was charged with obstruction of justice

related to the destruction of Enron documents (Berkowitz, 2002). Consequently, auditors, who were

once held in high esteem, have now started to be viewed as ineffective and complacent (Beasely

and Hermanson, 2004). The main causes of these audit failures are recognized in the audit

expectation gap and in the lack of the independence requirement. An abundant literature focuses on

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the first emphasized cause, i.e. the audit expectation gap. Auditing is the act of attesting to the

veracity of something, an evidentiary process analogous to the legal process of gathering evidence

to establish the “facts of the case”: the audit function plausibly can provide only assurance that

financial data correspond to certain specified events that have actually occurred. There is a gap

between the beliefs and the preferences of the auditors with respect to those of the users of

accounting reports (Baron, Douglas, Johnson, Searfoss & Smith, 1977; Salehi, 2011): the latter

assign to auditors a greater responsibility in discovering accounting manipulation and illegal acts

than the extent to which auditors feel themselves responsible for such a task.

Recent regulations have tried to reduce both this gap and the second emphasized cause of

audit failure, that is the lack of independence, by introducing some restrictions affecting the

decision to outsource the internal audit function (such as the Sarbanes–Oxley Act in the USA) to

external audit firms: after the notorious scandals, a fundamental change in the way audits are

performed was then needed to win back the public’s trust (Tackett, Wolf & Claypool, 2004).

However, some inquiries on the quality of auditing during the recent financial crisis show that

problems are far from being solved (Sikka, 2009), and other studies cast doubt on the likelihood that

the stricter internal controls imposed by recent regulations will be effective, if the “dramaturgical

exchanges between the SEC and corporate regulatees” will go on as they did in the past (Shapiro &

Matson, 2008, p. 224). Many studies have emphasized the importance of the programs for fraud

prevention/detection education and training programs to educate auditing professionals for fraud

prevention/detection: Aliabadi, Chen and Dorestani (2011) reveal that those who commit fraud are

not necessarily geniuses or have creative minds because they just copy fraud schemes from the past.

Therefore, there should be more emphasis on past mistakes, as we have already highlighted in the

introduction.

Unlike both the previous streams of literature, Guénin-Paracini and Gendron (2010), whose

work has already been mentioned above, emphasize the paradoxical nature of the legitimacy

surrounding the financial audit function in society. On the one hand, scandals surrounding

fraudulent financial statements typically result in a litigation against specific auditors while

generating reproaches targeted at the whole profession. On the other hand, in spite of lawsuits and

criticism, the influence of auditing as a technical means of control invariably continues to gain

strength, and the auditors’ moral legitimacy eventually is always restored in the eyes of most

stakeholders. In other words, the authors contend that auditors can be thought of as modern

-14-  

pharmakoi, constituting a reservoir of victims to sacrifice whenever the occurrence of some

fraudulent financial statements threatens the stability of the economic order.

Auditors have been scapegoated in the aftermath of a number of financial scandals, and the

process of their moral condemnation indeed bears some resemblance to the sacrificial rituals as

described and interpreted by Girard. However, in contending that auditors are modern pharmakoi,

Guénin-Paracini and Gendron (2010) do not state that auditors are systematically designated as

scapegoats in the aftermath of all financial crises, but only in a certain number of them. Starting

from their work, this paper aims to provide an explanation for some different fraud processes where

auditors are neither watchdogs nor victims nor legally guilty and to introduce the concept of

“creative auditing”. This represents one of the main focuses of this work, which is the first

comprehensive attempt, as far as we are aware, to identify another possible way of auditing, i.e.

creative auditing. It may be framed and related to the agency theory, as creative accounting was:

auditors (agents) may use their professional knowledge, asymmetrical information and the

flexibility inside auditing rules to distract the principals’ attention (owners, shareholders, investors,

etc.) from news which will not be welcome. In fact, according to the agency theory, information

asymmetry occurs where agents (auditors) enjoy a competitive advantage over principals (e.g.

owners, investors, etc.) because of the information they have from within the company. This results

in the principal’s inability to control the desired action of the agent (Godfrey, Hodgson & Holmes,

2003). Information within an organization is critical, and auditors working with the management of

a company are privy to essential information that can be used in a legal, but not proper way, to

maximize their own interests at the expense of the principal. This situation is worsened by the

shareholders’ (i.e. the principals’) role in public companies: they “are an amorphous group and their

ability to exert influence on their agents is diffuse and often indirect” (Brown, 2007, p. 181). For

such reasons, the possibility of collusion (Tirole, 1986; Strausz, 1997; Olsen & Torsvik, 1998)

arises between auditors and managers, as emphasized in some works: “Prior to scandal, many

assumed that either legal liability or reputational concerns would prevent the large audit firms from

engaging in collusion with their clients. Enron and the many frauds that followed have undermined

these assumptions” (Brown, 2007, p. 178).

Starting from these premises, in the following paragraphs we will develop the concept of

creative auditing as a tool to interpret and understand the peculiar role auditors were able to play in

Sunbeam Corp. (in relationship with both managers and shareholders). We will also tentatively

define the regulatory context where cases of creative auditing could emerge more frequently, in this

-15-  

way historically situating our theoretical effort and paving the way for further inquiries on the

matter.

3) MICRO-ANALYSIS OF THE DEVIANT CASE: A THICK DESCRIPTION OF THE

EVENTS.

Sunbeam Corp. has surely represented a case of accounting fraud. Many analysts were

initially persuaded that Albert Dunlap had improved the economic and financial situation of the

company: Sunbeam’s stock soared nearly 50 per cent the day Dunlap was hired to run the company

in 1996 and he became a sort of corporate star in the US Although Sunbeam’s fortunes initially

seemed to improve under Dunlap, as the company took a huge write-off in 1996 when it closed

plants and laid off employees, its reported profits soared in 1997: at that point, Dunlap and Russell

A. Kersh (a longtime close associate of the Sunbeam’s chief financial officer) orchestrated a

fraudulent scheme to create the illusion of a successful restructuring of Sunbeam and facilitate the

sale of the company at an inflated price.

The first point emphasized by the SEC concerns “the illusion of a successful restructuring of

Sunbeam in order to inflate its stock price and thus improve its value as an acquisition target”: the

SEC complaint against Sunbeam states that “at least $62 million of Sunbeam’s reported income of

$189 million came from accounting fraud” (SEC, 2001a). Among the many different fraudulent

accounting techniques used by Sunbeam from October 1996 to June 1998, the SEC focused on “the

improper recording of bill and hold sales”. Following the summary provided by Ryerson (2008, p.

149), these typically consist of anticipated purchase orders (“bills”) implying that the seller “holds”

the product until the buyer eventually needs it, and they should be recorded as sales only when “the

risk of ownership” is “passed to the buyer”, this being “one critical criterion for the proper

recognition” of a transaction. Improperly recorded “bill and hold” sales were inflating Sunbeam’s

1997 income by $62 million, and by a further $35 million the income of the first quarter of 1998.

As emphasized by the SEC in the above cited Release no. 1393, Al Dunlap’s claimed reorganization

was also based on several other improper practices such as the “cookie jar” reserves to create

improper profits in 1997 and the “channel stuffing” (i.e. putting inventory onto the books of

distributors and retailers) to reduce the value of inventory and to record large profits when the

goods were sold. Other irregularities regarded the discount policy which was used in order to push

sales and to convince customers to buy goods that they did not really need. According to the SEC,

those discounts should have been emphasized in the company’s reports.

-16-  

The second point emphasized by the above cited SEC (2001a; 2001b) concerns Dunlap’s

strategy to sell the company. As analyzed by several authors, starting from Laing (1998) and up to

Hill (1999, p. 1104), this strategy went wrong because Dunlap’s celebrity pushed Sunbeam stock to

premium levels, making it too expensive for most acquirers and making the sale of the company

itself impossible. Before that, Dunlap’s corporate sale strategy was profitably applied to Scott Paper

Co.: the CEO, also known as “Rambo in Pinstripes” for his cost-slashing and restructuring

techniques, had been around for a long time before Sunbeam (TABLE 4; Dunlap, 1996).

TABLE 2 - Highlights from Albert Dunlap’s Career (“Sunbeam dances with Mr. D.,” 1997; Stanwick & Stanwick, 2003)

Lily-Tulip: - In 1983, he fired all but two of the company’s senior managers on his first day at work.

Cut corporate staff by one half and cut 20% of the company’s workforce. - He took the company public in 1985. Crown Zellerbach: - Hired in 1986. - Split the natural resources company into two parts. In the part he kept, he laid off

approximately 20% of the company’s employees and renegotiated labor contracts to cut costs. Consolidated Press Holdings: - Began work in 1991 to restructure the company. - Sold most of the holding company’s businesses and revoked company perks. Scott Paper: - In April 1993, he laid off one-third of the company’s workforce. - In July 1995, a weakened Scott Paper was sold to Kimberly Clark for around $7 billion. Sunbeam: - Shortly after taking over, he replaced most of the senior management. - Three months after taking over, he announced 6,000 employees would be laid off.

Let us then recall how the events at Sunbeam developed in succession. In the early 1990s the

company had some problems due to bad performances and to the lost lawsuit against a former CEO

who was fired in 1992. In June 1996, the main shareholders were two private funds: Franklin

Mutual Advisers, a subsidiary of Franklin Resources Inc., with 22% of Sunbeam’s stock, and

Steinhardt Partners with 21%, each with a seat on the board of directors. However, in September, a

few months after Dunlap was hired, Steinhardt exited the board following on the decision taken at

the end of 1995 to close the hedge fund and return the stock to investors: Franklin Mutual remained

then the main shareholder, with Peter Langerman as its representative on the board (Browning & De

Lisser, 1996; Hill, 1999, p. 1101). So, when Al Dunlap became Sunbeam Corp’s CEO in July 1996,

there was the owners’ hope that this appointment would represent a turnaround for the company.

-17-  

The new CEO implemented, from the outset, the same strategy he had already successfully applied

when he headed other companies such as Scott Paper Co.: massive cuts to product lines, plants and

employees (Lublin & Brannigan, 1996).

The new CEO enjoyed full powers: of the five board members, four were chosen by Dunlap

himself (the fifth was Michael Price, as the main shareholder). Moreover, in the following year half

of Sunbeam’s 12,000 jobs were eliminated, approximately 90% of the products were discontinued,

and 18 of the 26 plants were closed (“Sunbeam dances with Mr. D.,” 1997). The implementation of

these same actions excited analysts’ expectations for higher profits, pushing the stock to over $45

per share in September 1997: at this point, Dunlap thought he was ready to sell Sunbeam (as he did

for Scott Paper Co.), but the sale could not be concluded despite the attempts of Sunbeam’s

investment bankers, who approached several companies, including Gillette, Black and Decker,

Rubbermaid, Maytag and Whirlpool. The unsuccessful sale was due to the price itself that

Sunbeam’s stock was traded at: when Dunlap took over Sunbeam in July 1996, the company’s

stock was trading at $12.50. A temporary downfall followed the announcement that Sunbeam was

for sale, culminating in January 1998, when the reported level of earnings in the fourth quarter of

1997 (47 cents per share) fell barely short of the expectations of Wall Street analysts (48 cents):

however, even with the stock trading under $38 per share, no other company seemed interested in

acquiring Sunbeam (see Fig. 2).

Following Sunbeam’s investment bankers’ failure in finding a buyer, Dunlap decided then

to use his company’s inflated stock to acquire other companies: in early March 1998, Sunbeam

declared it planned to buy three other companies, i.e. Coleman, Signature Brands and First Alert

(Kadlec, 1998). In the following days the stock price plunged again to close to $50 per share. On

March 30, 1998, the company, through a wholly-owned subsidiary, acquired approximately 81% of

the total number of the outstanding shares of common stock of the Coleman Company, Inc.

(“Coleman”), from a subsidiary of MacAndrews and Forbes Holdings, Inc. (“M&F”), in exchange

for 14,099,749 shares of Sunbeam’s common stock and approximately $160 million in cash as well

as the assumption of $1,016 million in debt. Coleman was a leading manufacturer and marketer of

consumer products for the worldwide outdoor recreation market. Its products had been sold

domestically under the Coleman brand name since the 1920s. The acquisition by means of share

exchange meant that Ronald O. Perelman, Coleman’s former majority shareholder, became with

14% of the stock the second largest shareholder of Sunbeam itself after Michael Price, who still

owned 17% and remained the only representative of shareholders on the board, as Perelman did not

take a seat (Pollock & Brannigan, 1998). On April 3, 1998, Sunbeam completed also the cash

-18-  

acquisitions of First Alert, Inc. (“First Alert”), a leading manufacturer of smoke and carbon

monoxide detectors, and Signature Brands USA, Inc. (“Signature Brands”), a leading manufacturer

of a comprehensive line of consumer and professional products. The First Alert and the Signature

Brands acquisitions were valued at approximately $178 million and $253 million, respectively,

including the assumption of debt. All the above acquisitions were accounted for in the budget by

using the purchase method and the results of the operations of the acquired entities were included in

the company’s Consolidated Statement of Operations starting from their respective acquisition

dates. In connection with the purchases of the three companies, Al Dunlap obtained new contracts

for himself and for Kersh too: in this way, Dunlap and Kersh doubled their salaries and beneficially

owned, respectively, 5% and 1% of the company. So, under these new agreements, they had even

greater incentives “to raise the price of Sunbeam’s stock and sell the Company to cash in all of these

holdings” (SEC vs. Dunlap et al., p. 41).

Fig. 2 - Sunbeam’s stock scheme.

The chart (Fig. 2) shows that public investors, ranging from individuals to investment funds, who bought and held Sunbeam’s stock in anticipation of a true turnaround, lost billions as a result of the scheme (SEC vs. Dunlap et al., p. 4).

-19-  

In April 1998, after the acquisition of the three above-mentioned companies and a first

warning of a slowdown in quarterly sales, “Sunbeam began to publicly unravel” (Byrne, 1999a),

and a wholly different story came to light. As it emerged when Sunbeam restated its financial

results, the company’s CFO Russell Kersh moved $21,500,000 from reserves into income and

shifted part of operating expenses into a 1996 restructuring charge in order to hide the reduction in

profits due to the hard discounts, credit extensions and “bill-and-hold” contracts used in order to

inflate revenues with sales that should not have already been wholly counted in (US General

Accounting Office [GAO], 2002, p. 202; Canedy, 1998). The story of the growing difficulties for

Sunbeam in keeping up with market expectations and with the announcements of the CEO himself

has been narratively reconstructed by John A. Byrne (1999b) in a book based on hundreds of

interviews with Sunbeam executives, managers, employees and directors and with Wall Street

analysts and investors. Dunlap was indeed setting unattainable goals, such as doubling sales in three

years, or increasing operating margins to 20% from 2.5%. According to Sunbeam’s employees,

“almost all executives believed these goals were impractical”, and, however, they did not refuse

their wages (Byrne, 1999a). Indeed, the employees’ testimonies and complaints collected by Byrne

reveal that Dunlap was not only urging his subordinates, from top executives to middle managers,

to do whatever they could to reach almost impossible targets on pain of dismissal, but also that he

was offering them much larger rewards in stock options than any other company if they met the

goal. So they found themselves trying any trick to increase returns and sales, delaying payments and

forcing customers to buy more than they needed by means of discounts and credit extensions that

were not in the reports.

Nevertheless, it should be noted that some analysts were able to detect from the early reports

that something was wrong: following Byrne’s account, the increase in inventory and the parallel

decrease in cash on hand from the first to the second quarter of 1997 alerted at least William H.

Steele of the San Francisco-based Buckingham Research Group, who downgraded Sunbeam’s stock

from “buy” to “neutral” in July 1997 (Byrne, 1999b, p. 152). However, the persistent optimism of

the company’s forecasts convinced most analysts and investors that Sunbeam was going to attain its

targets despite everything: this happened mainly because they were convinced, as even Andrew

Shore of PaineWebber Inc. said in October 1997, that “Sunbeam possesses an intangible asset, the

Dunlap factor” (Byrne, 1999a).

When, by June 1998, the stock had fallen to around $22 per share, following the stumbling

of profits, an analyst of Barron’s Online (Laing, 1998) was the first to investigate in detail the

reasons for such a sudden drop: Laing’s article disclosed that Sunbeam had realized a negative

-20-  

operating cash flow in 1997 and insinuated that the company implemented questionable accounting

practices (Norris, 2001a).

Although several analysts still continued to believe in Sunbeam and its CEO, the company

soon made a radical choice: the first decision (8 days after Barron’s discrediting article) regarded Al

Dunlap’s forced resignation because of both such “public” claims and employees’ assertions about

Dunlap’s way of working. By June 1998, the company’s directors had fired “Chainsaw Al”,

commenting that they had “lost confidence” in his leadership abilities (Mahabaj, 1998). Together

with Dunlap, also Kersh and the outside director William T. Rutter resigned from the board.

Franklin Mutual Advisers, as the main shareholder, appointed its representative, Peter Langerman,

as chairman of the board, and Lawrence Sondike as an additional director. Following the influential

suggestion of Ronald Perelman, the board then appointed Jerry W. Levin, the former CEO of

Coleman, as Dunlap’s successor at Sunbeam in an attempt to salvage of the company. Levin

immediately announced that a restatement of the 1997 results was forthcoming, and started working

for a recovery of the company (“Sunbeam warns of financial review,” 1998).

Perelman was not on the board of directors, but he was one of the main shareholders and he

was able to influence the choice of the new CEO. At the same time, he threatened the other

shareholders and the board that he would sue Sunbeam for the losses resulting from the Coleman

deal: this would have forced Levin to resign in order to avoid a conflict of interests, and pushed the

company into bankruptcy. In the meanwhile, in fact, the announcement that the SEC had started a

thorough investigation immediately after Dunlap’s dismissal had caused the company’s share price

to plummet to $10.4375. By July 14, 1998, the SEC had upgraded its investigation of Sunbeam to a

formal one (“SEC upgrades Sunbeam probe,” 1998). The investigation would centre around

premature recording of the sales of barbecue grills.

In August, the board finally agreed to grant Perelman, in compensation for his losses,

“warrants to buy 23 million shares of Sunbeam stock at $7 per share, which could raise his stake in

the company to 28%,” (Hill, 1999, p. 1133) thus virtually allowing him to take the control of the

company (Pollock & Brannigan, 1998). At this point, the company announced it had began to

recover from “Chainsaw Al” and Levin said they had no intention of going bankrupt (Connor,

1998). Finally, on October 20, 1998, Sunbeam announced its long-awaited restated results: the

restatement regarded the results from the last quarter of 1996 through the first quarter of 1998.

Sunbeam’s 1997 net income was decreased by $ 71 million and 1997 operating expenses were

mostly attributed to the previous year (GAO, 2002, p. 201). Al Dunlap argued that this restatement

-21-  

concerned “technical accounting issues” (Canedy, 1998; Stanwick and Stanwick, 2003), which had

been (or should have been) revised and approved by Sunbeam’s external auditors.

This announcement raised some questions also about external auditors’ position: on

December 1, 1998, several months after Dunlap’s discharge, Sunbeam dismissed Arthur Andersen

and named Deloitte & Touche as its new outside auditors (Eichenwald, 1998). In most of the fraud

cases, auditors declared that they had no knowledge of the improper accounting practices used by

the company. The Sunbeam case is different because Phillip E. Harlow, the Arthur Andersen partner

in charge of the Sunbeam audit, discovered some of the fraudulent transactions and asked the

company to change its financial statements.

In particular, Harlow focused on a specific fraudulent method of creating fake profits, the

so-called spare-parts gambit: Sunbeam owned a lot of spare parts, used to fix its blenders and grills

when they broke. Those parts were stored in the warehouse of a company called EPI Printers, which

sent the parts out as needed. The improper method consisted in selling the parts for $11 million to

EPI and booking an $8 million profit. Unfortunately, EPI thought the parts were worth $2 million.

But Sunbeam found a way around that. EPI was persuaded to sign an “agreement to agree” to buy

the parts for $11 million, with a clause letting EPI walk away in January. In fact, the parts were

never sold, but the profit was posted. Harlow claimed to have effectively discovered that and

concluded the profit was not allowed under generally accepted accounting rules, but the company’s

management refused to make most of the requested changes: Sunbeam agreed to cut it by just $3

million. After that, before deciding to sign, Mr. Harlow analysed Sunbeam financial statements

thoroughly and understood that the remaining profit was not material: this was the same as saying

that the part, which was not presented fairly, was not material, so it did not matter.

As emphasized by Norris (2001b), after the Sunbeam fraud disclosure, Harlow was

supported by his partner (Arthur Andersen), who stated this case involved not fraud, but

“professional disagreements about the application of sophisticated accounting standards”: “in the

typical accounting fraud case, the auditors say they were fooled. Here, at least according to the

SEC, the auditors discovered a substantial part of what the commission calls sham profits”. We may

say that stating the immateriality of a part of improper profits, they used their professional

knowledge, the asymmetrical access to information and the flexibility inside auditing rules to

distract other stakeholders’ attention from news which would not be welcome. For these reasons, we

may affirm that Sunbeam represents a case of creative auditing implementation. In fact, after

Dunlap was fired, Arthur Andersen (Harlow’s partner), along with another accounting firm, re-

-22-  

audited the books and concluded that the 1997 profits should have been far lower, but also that

Sunbeam’s external auditors acted better than the typical auditor in the typical accounting fraud.

Sunbeam’s 840 days path from fraud disclosure to bankruptcy (it filed for Chapter 11

bankruptcy protection on February 6, 2001 – “Sunbeam files for bankruptcy,” 2001) was rapidly

followed by the company’s announcement in 2002 that it had emerged from Chapter 11 bankruptcy

protection. This announcement came with a name change for the company, from Sunbeam

Corporation to American Household Inc. (“Sunbeam emerges from bankruptcy,” 2002). So, the

strange fraud path of Sunbeam seemed to have just one bad cause, whose elimination made it

possible to wait for so long before bankruptcy and a fast exit from it. In fact, only Al Dunlap was

banned from ever serving as an officer or director of a public company because of his actions as

Sunbeam’s CEO. He paid $500,000 to settle SEC charges and $15 million to settle a class-action

suit filed by investors (Brannigan, 2002; Norris, 2002).

The rapid recovery of the company actually allows some considerations on its actual

situation at the moment when Dunlap was fired: the collapse in the stock price depended more from

the uncertainty on the real situation of the company following the fraud disclosure than from an

actual discovery of a bankruptcy situation. We may say that what pushed the management to

commit fraud was in this case the gap between the actual performance and the exaggerated

expectations of the market, which the managers themselves were stirring in order to boost the value

of their stock options.

Dunlap’s worst mistake, at a management and corporate governance level, seems to have

been his tendency to surround himself with a few loyal executives from prior ventures: after

arriving at Sunbeam, Dunlap replaced almost all of top management with his own selections

(appointed as formally “independent” members of the board), who were also provided with strong

financial incentives to improve the company's stock price; and he quickly replaced all Sunbeam

board members except the major shareholder (Franklin Mutual, represented by Peter Langerman).

As the SEC complaint against him and other directors and managers of the company highlighted,

“throughout his tenure, Dunlap exercised complete, unfettered authority over all aspects of

Sunbeam’s business and staffing” (SEC vs. Dunlap et al., p. 8). Several authors have emphasized

his sudden passage from corporate star to criminal, from Sunbeam’s best intangible asset to its

worst liability. A business column, at the time of Sunbeam’s fraud disclosure and referring to

Dunlap, headlined: “He anointed himself America’s best CEO. But Al Dunlap drove Sunbeam into

the ground” (Byrne, 1999a). Dunlap suddenly shifted from being almost canonized as a “miracle

worker” by corporate America for his use of the “chainsaw” to downsize and make companies

-23-  

profitable and appealing for a buyer (Stewart, 1998), to being blamed as the sole culprit of

Sunbeam’s fraud because of his tendency to intimidate his managers by pushing them to “make up”

their numbers, as even Sunbeam top executives, when interviewed by Byrne (1999), were ready to

declare.

4) PUTTING THE CASE TO WORK, OR FROM THE CASE BACK TO THE SAMPLE

In this section, a basic question will be addressed: what does this case, which the SEC

investigated in depth and this paper analyses in detail, say about more general problems concerning

the relationship between fraud and failure path? The reply can start by building up a complex but

clear model in order to emphasize the factors (and their interactions) which can explain why

Sunbeam emerged as an outlier (from the sample concerning fraudulent US companies), employing

a such long time from fraud disclosure to bankruptcy. These factors and their relations are usually

discussed in the literature one by one and in terms of statistical correlations emerging from the

empirical study of large databases. This approach is necessary in order to test the general validity of

the causal theories of the researchers, but it is not sufficient (Parker, 2012) to understand how

different factors could be inter-connected. The approach used here, based on the micro-analysis of a

case, could instead provide interesting insights on how different factors could interfere with each

other, and how different lines of empirical research could then successfully be connected together in

order to reach a better understanding of fraud and failure mechanisms. Finally, since the case under

consideration was selected as an outlier in a statistical distribution, it is interesting to consider what

it could say by contrast about the average corporate fraudulent conduct: if it was an exception

because of some factors, it means that usually this combination of factors is not present.

Why was the Sunbeam story so exceptional? The narrative above suggests three main

elements to focus on: the over-manipulation of accounting information, the role of mergers and

acquisitions and “creative auditing” (a concept here introduced for the first time). The role of other

possible factors was considered relevant but not specific to Sunbeam, following the detailed

triangulation we performed by comparing the SEC report we used as the main narrative thread

above and the other sources we referred to in detail.

The first element (i.e. over-manipulation of accounting) concerns the fact that evidently

Dunlap over-boosted company performance that were not so bad, as the rapid recovery of the

company from a relatively painless macro-failure proves. Putting this elements into the framework

of the relation between fraud and bankruptcy, we may say that the micro-failure pushing the

-24-  

manager to commit fraud was perhaps not so relevant in this case, the motivation for the

manipulation of accounts being rather the gap with exaggerated expectations.

It should also be emphasized that Dunlap exaggerated and made pervasive some “boosting”

practices that were usual in any business, taking creative accounting “to another level” (i.e.

accounting fraud). This point has some interesting implications concerning the general diffusion of

creative accounting practices and undisclosed fraud, already partially discussed in the literature

mentioned in the second section. The exceptional overstatement of Sunbeam’s performance finds in

part its origin in a peculiar phenomenon of short circuiting between the higher-than-usual amount of

stock options entering managers’ executive pay and the effects that overstatement soon started

exerting on the stock price, providing top and middle managers with stronger and stronger

incentives to boost reported performances at any level of the company’s accounting process,

following the inputs coming from the CEO. This mechanism is in line with theoretical models (Bar-

Gill & Bebchuk, 2002; Goldman & Slezak, 2006) asserting that a connection exists between

performance-based compensation and misreporting practices (Erickson et al., 2006). However,

more interesting than the (general) causes of the exaggerated overstatement of Sunbeam’s

performance are its (peculiar) effects: the increase in the stock price was so high that it finally

prevented Dunlap from selling the company. This point raises a theoretical problem: what does it

mean to say that the price of a company stock exceeded the threshold for selling the company itself?

A stock is after all “a piece” of a company, isn’t it? Following the account of the events as reported

above, this paradox may be interpreted as the result of an inverted premium for control: an eventual

buyer would discount the fact that the company, once acquired, would lose its best non-replicable

“intangible asset”, the CEO himself. The question may also regard whether buyers really believed

in Sunbeam’s performances, but providing an answer would be difficult; certainly they did not

believe those performances were replicable.

The failed sale of the company has even another implication, concerning the reasons behind

it. The sale should have represented the final step of the process of business reorganization started

by Dunlap and the realization of the value created in that process, but it would then have

represented also a crucial step in the fraud process, making it possible to cover, under the so-called

“veil of acquisition”, all the problems that might emerge from the inaccurate and inappropriate

accounting practices preceding it. This finding has by contrast an important implication for the

ongoing research concerning accounting fraud, information uncertainty and acquisition losses

(Erickson et al., 2011; literature about disclosed and undisclosed frauds as summarized in Jones,

2011). Recent studies show that companies accused of committing accounting fraud are more prone

-25-  

to acquire other companies because they use acquisition (evidently without success) as a tool to

conceal the fraud itself (Erickson et al., 2011): Sunbeam was not an exception, as will be discussed

below. But the analysis of the case suggests that companies committing fraud look at the acquisition

of other companies only as a second-best strategy: they prefer to be acquired by other companies

because this would almost certainly provide a successful concealment of the fraudulent accounting

behaviour preceding the acquisition. Let’s say that the historical budgets of acquired companies

could be an interesting source for an empirical investigation on the diffusion of undisclosed fraud.

This emphasizes the importance of the second element listed above, i.e. the role of M&A. As

the sale of the company was impossible, Dunlap resorted to the second-best strategy of acquiring

other companies. The expediency of this choice is explained by two factors: it provided an

alternative, even if less effective, tool to conceal accounting fraud and it made it possible to use

over-valued company stocks as means of exchange (instead of money) for the acquisition. This

reveals another interesting short circuit in the Sunbeam story: Ron Perelman, Coleman’s former

majority shareholder, accepted Sunbeam stocks as payment for his majority participation in

Coleman, thus becoming the second-largest shareholder of Sunbeam itself. In fact, company

performances started showing some difficulties only two months after the triple acquisition was

completed, perhaps a little too early: it was evidently the unavoidable consequence of the short-term

profit-boosting practices described above (i.e. channel stuffing, bill-and-hold sales and the improper

transfer of reserves to incomes). The effect was a loss on the 1998 first quarter report and a

consequent collapse in the stock price. Laing’s (1998) analysis for Barron’s then started to alarm the

board, who fired Dunlap after a rapid inspection of the second-quarter results. Incidentally, this

confirms what has recently been pointed out in some empirical studies (e.g. Dyck, Morse &

Zingales, 2006): analysts represent the most effective early whistle-blowers of frauds. After

Dunlap’s dismissal, Perelman acquired the position of second major shareholder: in this way he was

allowed to support the appointment of Jerry Levin (i.e. the former CEO of Coleman) as the

successor to Dunlap in an attempt to salvage Sunbeam. The factual explanation of Sunbeam’s

exceptionally long time to failure can be found in this strategy pursued by Perelman: he tried to be

repaid for the losses by acquiring control of Sunbeam and trying to pursue its recovery after Al

Dunlap’s dismissal. In doing that, Perelman (and his long-time protégé Levin) played the part of the

acquirers, despite the fact that Perelman acquired the company only after fraud disclosure. From

this point of view, Perelman’s behaviour when coping with a disclosed fraud indirectly sheds some

light on the motivations of acquirers who abstain from reporting previous fraudulent statements of

the acquired entities that consequently remain undisclosed.

-26-  

Was Dunlap used as a scapegoat in order to solve the difficult mess the company found itself

in at that point? Without doubt he was, but this statement must be limited by defining scapegoating

as the act of making a single person guilty for what was certainly a more complex process (Guénin-

Paracini & Gendron, 2010, p. 136), even in the presence of direct responsibilities of the

“scapegoat”, as was evidently the case with Dunlap. Did the scapegoating of Dunlap, as the strategy

adopted by the board, and then by Perelman and Levin after the takeover of the company, explain

the exceptionally long time to failure after fraud disclosure? Not on its own. In fact, as explained

above, Sunbeam Corp. was selected for this case study because it emerged as an outlier from the

statistical analysis of a large database, and several interacting factors that may explain its

unusualness and uniqueness have been investigated in previous sections.

Creative auditing represents the third of the explanatory factors listed above, and we related

it to the hypothesis that the case of Sunbeam could be one of the last remaining signs of a blind path

in the evolution of auditing practices. The point here is that the auditing failure of Arthur Andersen

(Sunbeam's and then Enron’s external auditor) was made public and punished only after Enron’s

bankruptcy, as greatly emphasized in the business and scientific literature. It was in fact the

financial scandal surrounding the collapse of Enron that caused the erosion in the reputation of its

auditor, leading first to concerns about Andersen’s ability to continue in existence and ultimately to

the auditing firm’s demise. We should specify that Andersen’s involvement in previous fraud cases,

among which Sunbeam, caused prosecutors to consider the auditing firm a recidivist offender, and

led it to commit further offences in a desperate effort to avoid sanctions by destroying Enron-related

documents (Weil, Barrionuevo & Bryan-Low, 2002). Some studies suggest that Andersen’s way of

working was not significantly different in quality from that of other auditing firms: for instance,

Cahan, Zhang and Veenan (2011) have examined the period 1992–2001 using a sample of 11,907

Andersen client-year observations and found no overall evidence suggesting that Andersen’s audit

quality was lower relative to the Big 4 in the pre-Enron period. However, we may put forward the

hypothesis that the peculiar way the auditors dealt with materiality judgements in the case of

Sunbeam Corp. could be ascribed to a specific “firm culture”, borrowing this concept from

Carpenter, Dirsmith and Gupta (1994).

The collapse of Arthur Andersen generated a series of questions in the media and elsewhere

regarding the extent to which the financial audit function is controllable (Gendron & Spira, 2009)

and responsible in firms’ fraud. The report by Powers, Troubh and Winokur (2002) into the collapse

of Enron for the SEC identifies the significant failure of established safeguards, including: financial

accounting and reporting standards and public disclosure requirements; the role of auditors and

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oversight of the audit profession; and corporate governance regulations and practice. The report

indicates that, overall, many of the consequences of Enron’s failure “could and should have been

avoided”. Further financial scandals resulted in a “crisis of confidence” in American capitalism that

led to wide-ranging debates culminating in the Sarbanes-Oxley Act of 2002 which reformed, and

considerably strengthened, the regulation of accounting, auditing and corporate governance

(Raiborn & Schorg, 2004). After Enron, then, the primary purpose of a financial statement audit has

been stated in a stricter way: it consists in determining if a company’s financial reports properly

disclose its results. The responsibility for the preparation of such reports is attributed to the

company’s management, while the task of vouching for the accuracy of such statements (i.e. the

conformity with generally accepted accounting standards and the fair presentation of the company’s

financial position) is attributed to its external auditors. Given such a task, the latter should detect

and disclose material irregularities. This implies that external auditors “can be held liable for any

losses incurred by those who relied upon the misrepresented financial statements” (Buckhoff,

Higgins & Sinclair, 2010, p. 32). It happened and caused the downfall of Arthur Andersen, the

external auditor for Enron and previously for Sunbeam: the latter would probably not have been an

outlier in the statistical sample, from which it was selected, had the Enron fraud not drawn so much

attention to the auditing function, leading Enron faster to its final macro-failure, together with its

auditor, and implying such consequences in the legislation.

5) FINDINGS AND DISCUSSION

The main findings of this study are particularly interesting in the light of recent research on

the effectiveness of triangulating audit evidence in detecting financial statement fraud, but two

clarifications should be made. First, in emphasizing the Sunbeam manager’s role in the fraud

process, the study does not argue that managers are systematically designated as scapegoats in the

aftermath of all fraud processes. There is no determinism involved: the point is that managers may

be scapegoated in a fraud process. Second, in popular speech, the word “scapegoat” often implies

the innocence of the “scapegoated” party. Importantly, this is not the case in Girard’s theory, to

which we have made reference. For Girard, the scapegoat is not necessarily innocent. He can be

guilty, but he is not the only one: everybody is somewhat responsible for the crisis that the

scapegoat is accused of having provoked. In other words, by describing managers as scapegoats, the

study does not argue that they are immaculate.

One of the main findings regards “creative auditing”: this work is the first comprehensive

attempt, as far as we are aware, at identifying this different and possible way of auditing where

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agents (i.e. auditors) use their professional knowledge, asymmetrical information and the flexibility

of auditing rules to distract the principals’ (i.e. owners, shareholders, investors, etc.) attention from

news which would not be welcome. This results in the principals’ inability to control the desired

action of the agent: information within an organization is critical, and auditors working with

management of the company are privy to essential information that can be used in a legal, but not

proper, way to maximize their own interests at the expense of the principal. This said, there are at

least four implications to be drawn from this research, reflecting the operational research questions

posed in the introductory section. First of all, the investigation of a single, statistically exceptional

case, made it possible to explain the succession of the events in a way that could never be done with

a larger dataset, shedding light on a whole series of complex connections between accounting

manipulation, market performance, M&A choices, auditing, and the reactions to fraud disclosure.

Secondly, the unusual factors explaining Sunbeam’s exceptionally long time to macro-failure make

it evident that auditors do not usually distance themselves from the fraudulent practices (and are

consequently condemned), and the board of directors does not immediately replace (scapegoat) the

CEO discharging on her or him the whole responsibility for accounting manipulation. What is even

more interesting is the fact that fraudulent managers do not usually exceed in overstating the

performance and, in that case, they can succeed in selling the company before the fraud is disclosed.

Therefore, a third implication concerns the fact that some elements of the case could be exceptional

not because they are really unusual, but because they are part of an usually successful fraudulent

strategy: Sunbeam could not avoid fraud disclosure by means of the sale of the company and the

consequent concealment of manipulation thanks to the “acquisition veil” (even if, following

Perelman’s takeover, the case evolved in part as if the company had been sold). This point

interestingly suggests that a dataset rich in undetected cases of fraud could be found by studying the

budgets of companies that have been sold. On the other hand, the acquisition of another company

does not provide the same concealment effect as the sale of the company itself: the correlation

between fraud and acquisitions found by Erickson et al. (2011) should then be corrected if

undetected fraud cases were to be taken into account. A final implication regards the collapse of

Arthur Andersen which represented a sort of “historical turning point” for auditing and generated a

series of doubts about the extent to which the financial audit function is controllable (Gendron &

Spira, 2009) and responsible in firms’ fraud. After Enron, the primary purpose of a financial

statement audit has been stated in a stricter way (Sarbanes-Oxley Act of 2002): if properly planned

and conducted, a financial statement audit should uncover material financial statement fraud.

Sunbeam would have not represented an outlier in the statistical sample, from which it has been

selected, if the Enron fraud had not drawn so much attention to the auditing function, implied such

-29-  

legal consequences and hence increased the vigilance. In this perspective, the case analysed here is

strange as it represents one of the last remainings of a blind path in the evolution of auditing

practice.

This brings us to the limitations of this research. In fact, the analysis of a single case may

represent a drawback of the study. As explained in the introduction, the examined case was

statistically selected as an outlier from a sample of fraud cases extracted from a large database. The

decision to adopt a micro-analytical approach to investigate the outlier was then taken in the

hypothesis that this methodology could be the best tool to exploit what seemed to be a puzzling

secondary result of the statistical analysis. Indeed, transferring a method that was devised in order

to cope with the inherent idiosyncrasy of historical events to the field of accounting studies has

borne strange but rich fruits. Most of the study conclusions and implications pave the way for

further investigations that could assess by means of empirical quantification the scope and diffusion

of the causal mechanisms discovered to be at work here. Consequently, it can be said that this work

started from the results of statistical analysis, to which it now invites to return. What the micro-

analysis of a case can provide is indeed the possibility to sketch a model of the complex

mechanisms relating fraud and failure that is not based on the theoretical imagination of single

scholars, but on the actual investigation of a piece of reality, as exceptional as it may be, or better,

actually exploiting its own exceptionality: a carefully selected case can in fact become a logical

term of comparison, useful to suggest new general hypotheses about the characteristics and the

representativeness of the same dataset from which it was chosen.

-30-  

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