The link between corporate culture and fraud

The importance of the "tone at the top" in deterring fraud is a concept that most of us have read about in articles and studies. However, seeing tone at the top in practice and how it impacts an organization positively or negatively is the best way to understand exactly how this link works. (See Tone at the Top and the COSO Framework for Internal Control.)

Two recent cases illustrate the importance of the tone at the top by providing examples of how a poor tone can lead to improper financial reporting.

Toshiba

Consumer electronics and engineering company Toshiba announced in July that its CEO would step down in the aftermath of an investigation into the company's profit inflation scheme. Toshiba overstated operating profits by $1.9 billion (225 billion yen) over seven years going back to 2008. The September announcement of the scheme represents an even bigger correction than the $1.2 billion adjustment reported in July. (See Toshiba says it inflated profits by nearly $2bn over seven years, by Kana Inagaki, Financial Times, September 7, Toshiba just lost its CEO to a huge accounting scandal, by Geoffrey Smith, Fortune, July 21 and Toshiba Inflated Earnings by $1.2 Billion, a Panel of Experts Says, by Jonathan Soble, July 20, The New York Times.)

An 82-page summary of the investigation's findings stated that there "existed a corporate culture at Toshiba where it was impossible to go against the boss' will." And make no mistake about it. The investigation concluded that the earnings inflation was intentional, not something that could be attributed to accounting errors. The report described "a systematic involvement including by top management, with the goal of intentionally inflating the appearance of net profits."

Investigators interviewed 210 subjects, including the company's auditors, in connection with the investigation. They found problems in all six of Toshiba's major divisions particularly in the company's infrastructure division, in which they discovered 15 separate instances where employees established inadequate reserves for cost overruns and construction delays.

But underreporting of reserves was just one of several techniques the company used to pump up corporate profits. Other schemes investigators uncovered included understated costs of raw materials and components, early recognition of income (and in some cases recognizing income that shouldn't have been recognized at all) and delaying write-offs associated with cancelled contracts and other events (i.e. putting off the recognition of expenses for future periods).

The list of schemes covers all four areas commonly targeted when companies cook the books: inflating assets, understating liabilities, overstating revenues and underreporting expenses.

But more important than the nature of the schemes is the direct connection with Toshiba's corporate culture. This fraud started with senior management pressuring employees who interpreted that as implicit directions to cook the books. Many employees were ultimately involved in the massive scheme and cover-up. The report noted that Toshiba's accounting department "deliberately provided insufficient explanations to auditors, with the intention of carrying out a systematic cover-up."

The Toshiba case has many similarities to the Olympus case in its size and corporate culture. The $1.5 billion Olympus fraud, uncovered in 2011, also involved many years of cooking the books. Olympus executives hid losses on some of the company's speculative investments for 20 years. Some have concluded that Japanese cultural traditions might have led to the breakdown in the corporate tone at the top. Even the report from Toshiba's independent investigation referred to a system common in Japanese companies of a promise of lifetime employment in exchange for complete loyalty to the company. (See Toshiba scandal exposes Japan Inc.'s governance flaws, by Karyn Nishimura-Poupee, July 26.)

However, our next case shows that an impaired tone at the top can occur anywhere, regardless of historical traditions.

Hertz

In 2014, car rental company Hertz identified several accounting issues in previously issued financial statements for 2012 and 2013 that would require the issuance of restated reports, along with a restatement of unaudited figures from 2011. In June 2014, the company initiated an investigation into the causes of these misstatements. When Hertz filed its annual Form 10-K for 2014 late in July 2015, it identified 15 separate areas in the prior financial statements that required restatement spanning a variety of asset, liability, and expense accounts, including:

• Vehicle damage receivables and related allowances.
• Capitalization and timing of depreciation for non-fleet assets.
• Allowances for doubtful accounts receivable (in Hertz's Brazil operations).
• Accounts payable and accrued liabilities.

[The Form 10-K is an annual report required by the U.S. Securities and Exchange Commission (SEC) that gives a comprehensive summary of a company's financial performance.]

The restated results lowered pretax net income by $73 million, $90 million and $72 million for the years ended Dec. 31, 2011, 2012, and 2013, respectively. (See the July 17 PR Newswire release, Hertz Completes Financial Restatement; Provides 2015 Business Outlook.)

Unlike the Toshiba case, Hertz hasn't yet faced fraud allegations. The restatement is attributed to accounting errors rather than an intentional act of fraud — at least for now. However, there are several corporate culture parallels. Hertz's investigation revealed numerous internal control deficiencies in four of the five components of internal control. (Again, see Tone at the Top and the COSO Framework for Internal Control.) The most important weaknesses were those relating to the control environment at Hertz. The control environment embodies a company's tone at the top — its corporate culture. Hertz listed these control environment problems in its investigation report:

• An "inconsistent and sometimes inappropriate tone at the top," which resulted in departures from generally accepted accounting principles. Hertz even went so far as to say "… our former Chief Executive Officer's management style and temperament created a pressurized operating environment at the Company, where challenging targets were set and achieving those targets was a key performance expectation. There was in certain instances an inappropriate emphasis on meeting internal budgets, business plans, and current estimates."
• An insufficient complement of personnel with an appropriate level of knowledge, experience, and training commensurate with Hertz's financial reporting requirements.
• A lack of clear reporting structures, reporting lines, and decisional authority responsibilities.

Rarely has a company so clearly laid blame for financial reporting problems on a CEO (who resigned in September 2014) and other corporate environment issues that are the responsibility of senior management.

In one section of the Form 10-K, Hertz states that the tone and pressures imposed by the former CEO "may have been a factor influencing one or more employees to record an accounting entry now determined to be improper."

In the aftermath of the discovery of the errors, Hertz hired more than 20 new vice presidents and director-level accounting employees, including a new senior accounting team. The company also made changes in leadership in the business units associated with the restatements. These actions confirm that tone at the top goes beyond the management style and daily activities of senior executives. It also includes the actions management takes to ensure that a company is properly staffed with qualified personnel.

Culture of unspoken pressure

It's not surprising that senior management was involved in the Toshiba and Hertz cases. When employees perpetrate financial statement fraud, more often than not they commit it at the direction of the most senior management officials. In many cases, a handful of senior executives plan and carry out the scheme with little assistance from others.

What makes these cases interesting is that the fraud (or accounting errors in Hertz's case) involved many individuals who were influenced by a poor culture established by senior management. In both cases, employees felt compelled under extreme pressure to comply with or satisfy senior management even though, apparently, management didn't explicitly direct them to falsify financial reports.

When lofty financial goals become inherent commands to meet the numbers, we see cases such as Toshiba and Hertz.

Note: As this issue was being finalized, yet another case appeared in the news in which inaccurate financial reporting was blamed on the tone at the top. In a filing with the SEC, Marvell Technology revealed that it had uncovered improper revenue recognition and was in the process of investigating. "The investigation consists of a review of certain revenue recognition issues in the second quarter of fiscal 2016 and any associated issues with whether senior management's operating style during the period resulted in an open flow of information and communication to set an appropriate tone for an effective control environment," according to the SEC filing. (See Marvell's accounting problems may start at the very top, by Tomi Kilgore, MarketWatch, September 11.)

I'm always looking for recent cases and news involving alleged financial reporting fraud around the globe. Email me your links, news or information on public reports of alleged fraud.

Gerry Zack, CFE, CPA, CIA, is a managing director in the Global Forensics practice of BDO Consulting, at which he provides fraud risk advisory and investigation services. He's also the 2015 chair of the ACFE Board of Regents and an ACFE faculty member. His email address is: gzack@bdo.com.

Correction

In the July/August 2015 "ACFE Cookbook" column, under the Page 10 subhead, "Olympus agrees to pay Japanese investors $92 million," Olympus will pay 11 billion yen (not million) in an out-of-court settlement, and six banks filed suit demanding 28 billion yen (not million).   

Tone at the top and the COSO framework for internal control

The Committee of Sponsoring Organizations (COSO) first published a framework for internal control in 1992. In 2013, it published a revised framework, which clarified and built upon the 1992 document. (See the 2013 publication, Internal Control — Integrated Framework.)

The COSO framework identifies five interrelated components of internal control:

1. Control environment.
2. Risk assessment.
3. Control activities.
4. Information and communication.
5. Monitoring.

The tone at the top of an organization is embodied within the control environment component. COSO provides five underlying principles that support the design and implementation of an effective control environment:

1. Personnel at all levels demonstrate a commitment to integrity and ethical values.
2. The board of directors is independent from management and oversees the development and performance of internal control.
3. With board oversight, management establishes the structure, reporting lines, and appropriate authorities and responsibilities in the pursuit of organizational objectives.
4. The organization demonstrates a commitment to attract, develop, and retain competent individuals in alignment with objectives.
5. The organization holds individuals accountable for their internal control responsibilities in the pursuit of objectives.

The objectives of internal controls that are referred to in the COSO framework concern three areas:

1. Operations.
2. Reporting (financial and nonfinancial).
3. Compliance.

In the Toshiba and Hertz cases, both companies compromised the financial reporting objective.