Assessment of Tone at the Top A C C O U N T I N G & A U D I T I N G a u d i t i n g JUNE 2015 / THE CPA JOURNAL50 By Susan S. Lightle, Bud Baker, and Joseph F. Castellano The Psychology of Control Risk Assessment Standards require that auditors assess an entity’s internal controls over financial reporting (ICFR), includ- ing the control environment, which is influenced by the tone set by management and the board regarding the importance of ICFR and the expected standards of employee conduct. This article argues that auditors cannot assess the tone at the top by simply checking off a list of control mechanisms; they must understand what motivates behavior within the organization (what might be called the psychology of control risk assess- ment). It also illustrates a model to help auditors anticipate when an organization is prone to earnings manipulation, and suggests how to assess the tone at the top of an organization. In Brief JUNE 2015 / THE CPA JOURNAL 51 I n the late 1960s and early 1970s, the U.S.-based energy conglomerate ITT put together a remarkable string of earnings increases under the leadership of Harold Geneen: ITT increased its net earnings each and every quarter, for 58 consecutive quarters, or more than 14 years of Geneen’s 18-year tenure. Geneen was lionized for this achievement; he became the highest paid executive in the United States, authored best-selling books, and was memorialized across the country in the form of new centers, buildings, and foun- dations (Harvey D. Shapiro, “Management Was the Message,” New York Times, March 10, 1985, http://www.nytimes. com/1985/03/10/books/management-was- the-message.html). Only in retrospect, after Geneen’s departure and the subsequent dis- mantling of most of ITT, did it become clear that those 58 straight quarters of growth were not what they seemed to be. The Price of Success Earnings management—a benign euphemism for financial manipulation— is not a wholly irrational activity, albeit an unethical one. In addition to the praise heaped upon high flyers like ITT under Geneen, researchers have demonstrated that companies reporting 20 consecutive quar- ters of earnings increases enjoy greater profitability, higher stock valuations, and higher price-earnings ratios than counter- parts with similar underlying financial strength (James N. Myers, Linda A. Myers, Douglas J. Skinner, “Earnings Momentum and Earnings Management,” August 2006, http://ssrn.com/abstract=741244 or http://dx.doi.org/10.2139/ssrn.741244). But Myers, et al., also showed that this “success” comes with a price: All those previously positive measures decline markedly when the unbroken sequence of quarterly successes finally ends; the longer the quarterly streak of good news runs, the deeper the firm’s plunge when the time of reckoning arrives. Efforts to manipu- late earnings are practiced by widely dis- parate companies and CEOs, whether lit- tle known or famous; publicly regarded as miscreants or su.

1. Assessment of Tone at the Top
A C C O U N T I N G & A U D I T I N G
a u d i t i n g
JUNE 2015 / THE CPA JOURNAL50
By Susan S. Lightle, Bud Baker, and Joseph F. Castellano
The Psychology of Control Risk Assessment
Standards require that auditors assess an entity’s internal
controls over financial reporting (ICFR), includ-
ing the control environment, which is influenced by the tone set
by management and the board regarding
the importance of ICFR and the expected standards of employee
conduct. This article argues that auditors
cannot assess the tone at the top by simply checking off a list of
control mechanisms; they must understand
what motivates behavior within the organization (what might be
called the psychology of control risk assess-
ment). It also illustrates a model to help auditors anticipate
when an organization is prone to earnings
manipulation, and suggests how to assess the tone at the top of
an organization.
In Brief
JUNE 2015 / THE CPA JOURNAL 51

2. I
n the late 1960s and early 1970s, the
U.S.-based energy conglomerate ITT
put together a remarkable string of
earnings increases under the leadership
of Harold Geneen: ITT increased its net
earnings each and every quarter, for 58
consecutive quarters, or more than 14 years
of Geneen’s 18-year tenure. Geneen was
lionized for this achievement; he became
the highest paid executive in the United
States, authored best-selling books, and was
memorialized across the country in the
form of new centers, buildings, and foun-
dations (Harvey D. Shapiro, “Management
Was the Message,” New York Times,
March 10, 1985, http://www.nytimes.
com/1985/03/10/books/management-was-
the-message.html). Only in retrospect, after
Geneen’s departure and the subsequent dis-
mantling of most of ITT, did it become
clear that those 58 straight quarters of
growth were not what they seemed to be.
The Price of Success
Earnings management—a benign
euphemism for financial manipulation—
is not a wholly irrational activity, albeit
an unethical one. In addition to the praise
heaped upon high flyers like ITT under
Geneen, researchers have demonstrated that
companies reporting 20 consecutive quar-
ters of earnings increases enjoy greater
profitability, higher stock valuations, and

3. higher price-earnings ratios than counter-
parts with similar underlying financial
strength (James N. Myers, Linda A. Myers,
Douglas J. Skinner, “Earnings Momentum
and Earnings Management,” August 2006,
http://ssrn.com/abstract=741244 or
http://dx.doi.org/10.2139/ssrn.741244).
But Myers, et al., also showed that this
“success” comes with a price: All those
previously positive measures decline
markedly when the unbroken sequence of
quarterly successes finally ends; the longer
the quarterly streak of good news runs, the
deeper the firm’s plunge when the time
of reckoning arrives. Efforts to manipu-
late earnings are practiced by widely dis-
parate companies and CEOs, whether lit-
tle known or famous; publicly regarded
as miscreants or successful individuals;
American, multinational, or foreign (Sheila
Keefe, “A $1.7 Billion Fraud Born of
Earnings Management and a Poor Ethical
Culture,” ACFE Insights, Feb. 6, 2012,
h t t p : / / w w w . a c f e i n s i g h t s . c o m /
acfe-insights/2012/2/6/a-17-billion-fraud-
born-of-earnings-management-and-a-poor-
et.html).
How Internal Controls Fail
Recognizing the undesirable effects of
earnings manipulation, legislators and
researchers have turned their attention to
the integrity of the financial reporting

4. system. The Sarbanes-Oxley Act of 2002
(SOX) increased penalties for financial
misreporting and raised auditors’ respon-
sibility for internal controls over financial
reporting (ICFR). Still, surveys and inter-
views of chief financial officers reveal that
CFOs believe that 20% of companies prac-
tice some form of earnings management
(Ilia D. Dichev, John R. Graham, Campbell
R. Harvey, Shivaram Rajgopal, “Earnings
Quality: Evidence from the Field,” May 7,
2013, http:// ssrn.com/ abstract= 2103384).
Other authors have discussed the tremen-
dous pressure upon CEOs to “make their
numbers” to show results for investors,
analysts, and directors; failure to meet these
expectations results in plunging stock prices
and plummeting careers, which are espe-
cially threatening to executives who occu-
py les s s ecure positions (Te rry L.
Campbell, Melissa B. Frye, Weishen
Wang, “How Do Entrenched Managers
Handle Analyst Pressure?” 2009, http://
www.fma.org/Reno/Papers/ Analyst
Pressure CampbellFryeWang.pdf). In addi-
tion to protecting the stock price and sat-
isfying board expectations, CEOs may be
motivated to commit financial reporting
fraud to meet bonus and compensation tar-
gets. Ego may be another factor, especial-
ly in situations where the CEO was brought
in to turn around a failing company.
The tone at the top of the organization
can strengthen internal controls or cir-

5. cumvent even the most sophisticated man-
agement control systems. Controls
designed to strengthen the control envi-
ronment and tone at the top include an
engaged board and audit committee with
a zero tolerance policy regarding aggres-
sive accounting manipulations, as well as
compensation policies that focus on long-
term, as opposed to short-term, outcomes.
Other relevant controls are the implemen-
tation and enforcement of an effective code
of ethics and a whistleblower policy that
encourages internal reporting of question-
able accounting practices. While it is man-
agement’s responsibility to design and
implement ICFR, ultimately the board
oversight is the most effective way to
assure that such controls are in place.
This article focuses on the external audi-
tor’s assessment of the risk of fraudulent
financial reporting. Fraud risk assessment
includes consideration of the “fraud trian-
gle” (i.e., the motivation, opportunity, and
rationalization or attitude that are typical-
ly present when fraud is committed). The
motivation to commit financial reporting
fraud is well understood. Controls designed
to limit the opportunity to commit report-
ing fraud are well defined in the auditing
literature. There is less guidance avail-
able, however, with respect to the assess-
ment of the attitude of management toward
earnings manipulation. A model bor-
rowed from the organizational behavior lit-

6. erature can help address this question.
How does an auditor assess tone? What
are the signs of a corrupted tone at the top
of an organization, one that is so focused
on earnings manipulation that all other con-
trol mechanisms are rendered useless?
Assessing the Tone at the Top
An auditor’s assessment of ICFR is used
to evaluate the risk that a company’s finan-
cial statements are materially misstated and
to determine the extent of testing necessary
to attest to the fairness of the financial state-
ment presentation (SAS 122, AS 12).
Professional standards provide some guid-
ance: For example, the Committee of
Sponsoring Organizations of the Treadway
Commission (COSO) framework outlines
principles associated with each component of
internal control, including the control envi-
ronment. In accordance with these principles,
the auditor must look for evidence that the
organization demonstrates a commitment to
integrity and ethical values (COSO, “Internal
Control–Integrated Framework Executive
Summary,” May 2013).
The principles of a sound control envi-
ronment include a board of directors that
exercises independent oversight of the devel-
opment and performance of internal controls.
With board oversight, management should
establish structures, reporting lines, and appro-
priate authorities and responsibilities in the

7. pursuit of objectives, as well as a commit-
JUNE 2015 / THE CPA JOURNAL52
ment to attract, develop, and retain compe-
tent individuals in alignment with the objec-
tives. Finally, the organization should hold
individuals accountable for their internal con-
trol responsibilities in the pursuit of objec-
tives (COSO, p. 6).
Auditors’ efforts to achieve these goals
may involve obtaining evidence through
interviews or surveys of employees, man-
agement, and others; review of policy man-
uals and established procedures; and obser-
vation of operations within the organiza-
tion. For example, an auditor might ask if
the client has a code of conduct, and, if so,
review it and the company’s policy regard-
ing the dissemination and enforcement of
the code—most important, however, is the
attitude of respect for the controls. If the
tone at the top is superficial compliance
underlying an understanding that controls
will not be permitted to get in the way of
meeting earnings targets, then the code of
conduct is worthless.
Assessment of tone at the top is also part
of the auditor’s consideration of fraud in a
financial statement audit. Auditing standards
identify three characteristics of fraud: 1)

8. incentive or pressure to commit fraud, 2) a
perceived opportunity to do so, and 3)
some rationalization of the act (AU-C sec-
tion 240.A1). The risk of fraudulent finan-
cial reporting increases if top management
has an incentive, opportunity, and rational-
ization to distort the reported financial posi-
tion and results of operations. Management
stock options or bonuses dependent on finan-
cial targets can create enormous pressure to
manipulate the financial statements (Financial
Fraud Law Report, September 2013, http://
socially responsible accounting. com/index/ wp-
content/uploads/2013/08/Kravitz- FFLR-Sept-
2013.pdf), and weak internal controls over
the processing of adjusting entries at year-
end might create the opportunity to do so.
And a tone at the top that values “making
the numbers” at all cost provides a conve-
nient rationalization for committing fraud.
The authors suggest a model, adapted from
Anne Wilson Schaef and Diane Fassel’s
identifiers of “addictive” organizations, which
auditors can use to assess the culture of the
underlying reporting environment, and apply
their model to the phenomenon of earnings
management (The Addictive Organization,
Harper, 1988, p. 58). This may help audi-
tors better anticipate and identify financial
reporting irregularities.
Organization as Addict
Schaef and Fassel define addiction as a

9. substance or process that takes over the
addict’s life, functioning as a buffer
between the addict and reality. They see
the addictive organization as a closed sys-
tem (i.e., it does not recognize informa-
tion that cannot be processed within its
existing paradigm) that exhibits many of
the characteristics of an individual addict.
In addition, it displays certain underlying
characteristics that serve to support the
addiction. The following characteristics can
be applied to a destructive preoccupation
with managing earnings:
n Focus on the hope that things will get
better in the future
n A “pseudopodic” ego—superficial open-
ness to new ideas, while the system actu-
ally absorbs the idea, modifies it so that it
can be incorporated into its existing
paradigms, and then uses it to perpetuate
the existing system intact
n External referencing—judging success
solely upon the perceptions of others
n Invalidation—redefining into nonexis-
tence those ideas and experiences that do
not fit into the existing paradigms
n Dualism—simplifying problems into two
choices, creating a false sense of stability
and discouraging creative solutions.
The common thread in all of these
underlying characteristics is that they allow
the organization to reject information that
it does not want to acknowledge, just as
individual addicts ignore warning signals

10. that their addiction is harmful, or even
life threatening. By being aware of these
characteristics, auditors may be better
able to identify a toxic control environment.
Things will get better in the future. It
is not uncommon for companies to expe-
rience temporary earnings reversals in light
of normal business cycles. If the corpora-
tion is overly focused on meeting revenue
and earnings targets to meet Wall Street’s
expectations, management may be tempt-
ed to use accounting ploys or management
practices to smooth out or even to elimi-
nate these normal downturns. In some
cases, financial reporting fraud is the
method of choice.
The case of HealthSouth is one of the
more egregious examples of the lengths
to which a company may go to meet ana-
lysts’ expectations. In March 2003, the
SEC charged HealthSouth and its CEO,
Richard Scrushy, with accounting fraud
through systematically overstating earnings
by at least $1.4 billion since 1999.
Independently, the Justice Department used
information from the company’s executives
to identify another $1.1 billion of overstated
earnings (Leonard G. Weld, Peter M.
Bergevin, Lorraine Magrath, “Anatomy
of a Financial Fraud,” The CPA Journal,
October 2004).
SEC Director of Enforcement Stephen
Cutler stated in a March 2003 press release

11. that “HealthSouth’s standard operating pro-
cedure was to manipulate the company’s
earnings to create the false impression
that the company was meeting Wall
Street’s expectations.” In a talk given to
the University of Chicago’s Booth School
of Business in May 2011, Weston Smith,
former HealthSouth CFO, told students that
fraud starts “with thoughts like, ‘This is
just temporary … We can’t disappoint
Wall Street … Everybody does it”
(Kadesha Thomas, Chicago Booth News,
http://www.chicagobooth.edu/news/
2011-05-31-healthsouth.aspx). However,
If the tone at the top is superficial compliance
underlying an understanding that controls will not be
permitted to get in the way of meeting earnings
targets, then the code of conduct is worthless.
JUNE 2015 / THE CPA JOURNAL 53
this addictive characteristic may be what
endangers the firm’s future.
Auditors need to be particularly cautious
when a client insists that things are turn-
ing around and will get better in the future,
particularly with respect to temporary cut-
backs and crisis-based schemes advocated
by management. An auditor must careful-

12. ly assess the motives behind such actions
in light of the real economic circumstances
confronting the company, industry, and
economy. It is especially important to ques-
tion management’s intended reversal of any
previously established reserves that have
the effect of increasing earnings in order
to meet earnings estimates. Such scrutiny
is even more crucial when executive
compensation packages are directly tied
to these earnings targets. The kinds of gim-
mickry discussed here may indicate that
management is willing to sacrifice its
integrity and the long-term best interests of
the company in order to please analysts and
maximize bonuses.
Pseudopodic ego. The pseudopodic ego
refers to the tendency of addicts to absorb
and then neutralize threatening new ideas.
The earnings-addicted organization will
make a show of playing by the rules, while
undermining them behind the scenes.
In 1993, Cynthia Cooper was hired by a
company called LDDS (renamed
WorldCom) to start an international audit
department. Having an internal audit func-
tion was not required at the time, but it was
considered a best practice by most large
corporations. The company’s CEO, Bernie
Ebbers, initially liked the idea of an internal
audit function because the first audit report
included useful recommendations for improv-
ing operational efficiency and effectiveness.

13. However, the honeymoon between Ebbers
and his new internal audit director ended
abruptly when she issued a report that was
critical of the company’s internal controls. In
her book, Cynthia Cooper describes Ebbers’
reaction to the report: “‘What are these
comments you’ve put in here about internal
controls?!’ he says, agitated. His face is blood
red. I’ve never seen him so upset”
(Extraordinary Circumstances: The
Journey of a Corporate Whistleblower,
Wiley, 2008, p. 114).
Several days later she was informed by
a member of the executive management
team that Ebbers didn’t want her to use the
words “internal controls” in her audit
reports because “it aggravates him”
(Cooper 115). Ebbers absorbed the idea
of an internal audit function, but neutral-
ized it when it became threatening.
Assessment of ICFR is the central func-
tion of internal auditors. As Cooper put it,
“asking an internal auditor not use the words
‘internal controls’ is like asking a physi-
cian not to use the word ‘prescription’”
(Cooper 115). Despite the unsupportive
(sometimes openly hostile) environment in
which she found herself, Cooper and her
team would eventually uncover a financial
reporting fraud that overstated the compa-
ny’s assets by $11 billion, one of the largest
frauds in U.S. history.

14. By creating an internal audit department
and then subverting its function, Ebbers
displayed an extreme example of a pseu-
dopodic ego. In their assessment of tone at
the top, auditors must pay particular
attention to management behavior that out-
wardly supports sound ICFR practices, but
in reality undermines their effectiveness.
External referencing. External refer-
encing is judging success only by the per-
ception of others. Of course, sound man-
agement practices dictate some level of
concern for how the organization is per-
ceived by others, including current and
potential shareholders, customers, suppli-
ers, regulators, and the general public. In
the addicted organization, however, man-
aging the perception of others (particular-
ly Wall Street) becomes obsessive, driving
short-term decisions that are detrimental to
the long-term health of the entity.
The saga of Al Dunlap provides a case
study of external referencing. At the height
of his career, Dunlap was seen by many as
a miracle worker, a leader who could turn
around the most desperate and catastrophic
situations. On the day in July 1996 that he
was appointed CEO of the troubled appli-
ance maker Sunbeam, the stock price soared
49%. Such was his celebrity that the mere
announcement of his hiring added $500 mil-
lion to Sunbeam’s market capitalization
(Sunbeam Corporation, “‘Chainsaw Al,’
Greed, and Recovery,” http://danielsethics

15. .mgt .unm.edu).
But by mid-1998, the miracle was gone.
Caught up in a channel-stuffing scheme—
inducing customers to take title to goods
that would normally have been sold in a
later period—designed to manipulate
Sunbeam’s earnings, Dunlap was dismissed
by the very board that had so confidently
hired him less than two years before. As
more details became clear over the ensu-
ing months, it was obvious that channel
stuffing was just one of the earnings man-
agement stratagems that Dunlap had fos-
tered (SEC Litigation Release 17001, “SEC
Sues Former Top Officers of Sunbeam
Corporation and Arthur Andersen Auditor
in Connection with Massive Financial
Fraud,” May 15, 2001, http://www.sec.gov/
litigation/litreleases/lr17001.htm).
Dunlap’s obsession with the daily—even
hourly—price of Sunbeam’s stock, and
its relationship to short-term earnings,
was well known. Nor should anyone have
been astonished that he would pressure
subordinates to do whatever was necessary
to meet earnings targets. Dunlap’s best-
selling 1996 autobiography, Mean
Business, was published just as he took
over as Sunbeam’s CEO. In the book,
Dunlap made his views crystal clear:
When it comes to a company’s stock price
and its daily fluctuations, I believe there

16. JUNE 2015 / THE CPA JOURNAL54
is always someone accountable. If the
stock price goes up, there is a reason. If
the stock price goes down, there is also a
reason … I pay great attention to the
hourly ups and downs … The stock
price drives me. (Albert J. Dunlap, Bob
Andelman, Mean Business: How I Save
Bad Companies and Make Good
Companies Great, Times Books/
Random House, 1996, p. 256)
One might argue that a leader as cele-
brated as Dunlap could have focused on
running Sunbeam effectively, trusting that
the stock market and analysts would rec-
ognize his superior performance in the
longer run. But instead, his short-term
manipulations sent the company into a tail-
spin from which Chapter 11 bankruptcy
was the only option (SEC Litigation
Release 17001).
Auditors must pay particular attention to
key performance indicators that are mon-
itored by financial analysts. Behavior that
results in the manipulation of such indica-
tors may be a sign of external referenc-
ing. Even if the client justifies the account-
ing treatment on the basis of a technicali-
ty, auditors should view such behavior as
possible evidence of external referencing.

17. Invalidation. Schaef and Fassel see inval-
idation as the rejection of ideas and experi-
ences that do not fit existing paradigms. One
of the consequences of invalidation in an
organization is the increased risk of impor-
tant information and knowledge being lost,
or simply rejected and ignored. Invalidation
was clearly in evidence in the Enron case.
Clinton Free chronicles how the leadership
style of CEO Jeff Skilling created a culture
at Enron that was able to overcome and cir-
cumvent the sophisticated management con-
trol systems that were in place (Clinton Free,
Norman Macintosh, and Mitchell Stein,
“Management Controls: The Organizational
Fraud Triangle of Leadership, Culture and
Control in Enron,” Ivey Business Journal,
July/August 2007). In effect, a corrupted
leadership and culture, what Free calls the
organizational fraud triangle, was able to
invalidate an elaborate and sophisticated
set of management controls.
It’s worth noting that invalidation often
involves rejection of not only the dissonant
message, but also of the source of that
message—that is, the best way to invalidate
the criticism is to denigrate the critic. From
a book on Enron:
Skilling, in particular, was infamous for
dividing the world into those who ‘got
it’ and those who didn’t … On the rare
occasions when Skilling was pressed, he

18. would react with scorn. ‘He did not want
to be crossed in any manner, shape, or
form … If you asked a question he did-
n’t want to answer, he would dump a
ton of data on you. But he didn’t answer.
If you were brave and said you still did-
n’t get it, he would turn on you. ‘Well,
it’s so obvious,’ he’d say. ‘How can you
not get it?’ So the analysts and investors
would pretend to get it even when they
didn’t. (Bethany McLean, Peter Elkind,
The Smartest Guys in the Room: The
Amazing Rise and Scandalous Fall of
Enron, Portfolio, 2003, p. 233)
The tone set by Skilling permeated the
organization. One central feature of Enron’s
management control system was their risk
assessment and control group (RAC). This
group was responsible for approving the
firm’s trading deals and assessing risk.
Another key component of Enron’s con-
trol system was the peer review commit-
tee (PRC), designed to ensure that employ-
ee actions aligned with the company’s
strategic objectives. Under this system,
each employee received an evaluation
every six months. Those falling into the
bottom 15% had two weeks to find
another job at Enron or were fired,
regardless of their performance (Free 4).
The culture at Enron became one of laud-
ing risk taking, pressure to make trading
deals regardless of risk, and when necessary,

19. managing earnings in order to meet analysts’
expectations. Over time, members of the
RAC became increasingly reluctant to turn
down any trading deals for fear of receiv-
ing poor evaluations in the PRC process and
for fear of Skilling’s reaction (Free 8).
Former employees Peter C. Fusaro and Ross
M. Miller indicated that Enron’s “rank-and-
yank” PRC system created “an environment
where employees were afraid to express their
opinions or to question unethical and
potentially illegal business practices. Because
the rank-and-yank system was both arbitrary
and subjective, it was easily used by man-
agers to reward blind loyalty and quash
brewing dissent” (What Went Wrong at
Enron: Everyone’s Guide to the Largest
Bankruptcy in U.S. History, Wiley, 2002).
What Fusaro and Miller described is a
classic example of invalidation. Auditors
should take note of management policies
that effectively stifle open communication
and free exchange of ideas. When man-
agement policies create pressure to con-
form, fraudulent behavior will not be chal-
lenged within the organization.
Dualism. Dualism refers to a false dichoto-
my in which an addict structures a problem
so as to eliminate any reasonable alternative
EXHIBIT
Warning Signs of Earnings Addiction
Characteristic Warning Sign

20. Belief that “things Management makes decisions based on
overly optimistic
will get better” assumptions about future financial or
operational conditions.
Pseudopodic ego Management undertakes actions that
effectively subvert or
circumvent existing rules, regulations, or control mechanisms.
External referencing Management uses accounting technicalities
to manipulate key
performance indicators in order to gain approval from outside
stakeholders.
Invalidation Management implements policies that stifle
information that
does not conform to management’s thinking.
Dualism Management insists on an “either-or” problem
definition that
drives a particular accounting treatment despite questions of
its appropriateness.
JUNE 2015 / THE CPA JOURNAL 55
(i.e., “I take this drug, or my life is not
worth living”). Organizations can think the
same way. In 2009, the SEC fined General
Electric (GE) $50 million for a scheme in
which GE took credit for sales of hundreds
of locomotives in the last month of two
consecutive fiscal years, even though own-
ership of the train engines did not transfer

21. until the following year. This was no trivial
shift: $370 million in revenue was misstated,
and the subterfuge involved more than half
of GE’s fourth-quarter locomotive produc-
tion: 223 engines of the 406 sold in the last
quarters of 2002 and 2003.
GE had met or exceeded earnings-per-
share expectations in every quarter since
1995. Allowing that string to be broken
was unthinkable to the GE financial staff:
In their minds, they had to either meet the
numbers, or the corporation would be
embarrassed and shareholders punished.
The SEC charged that during 2002 and
2003, “high-level GE accounting execu-
tives or other finance personnel approved
accounting that did not comply with
Generally Accepted Accounting Principles”
in order to hit the EPS estimates” (SEC v.
General Electric Co., 2009, http://www.
sec.gov/litigation/complaints/2009/
comp21166.pdf).
From an auditor’s perspective, dualism
may present itself as a stubborn resistance
on the part of the client to rational analy-
sis of a particular transaction or class of
transactions. GE’s insistence on recording
the sale of the locomotives is more than an
accounting irregularity. It is evidence of a
mindset, one in which fraud becomes seen
as an acceptable alternative.
Responding to Warning Signs
The presence of the warning signs

22. described above may indicate a high risk of
fraudulent financial reporting. Auditing stan-
dards dictate that the auditor must modify
the planned audit procedures to address a
high assessed level of fraud risk. Specifically,
the auditor should do the following:
n Assign and supervise personnel, taking
into account the knowledge, skill, and abil-
ity of the individuals to be given signifi-
cant engagement responsibilities and the
auditor’s assessment of the risks of mate-
rial misstatement due to fraud for the
engagement
n Evaluate whether the selection and appli-
cation of accounting policies by the enti-
ty, particularly those related to subjective
measurements and complex transactions,
may indicate fraudulent financial reporting
resulting from management's effort to man-
age earnings or a bias that may create a
material misstatement
n Incorporate an element of unpredictabili-
ty in the nature, timing, and extent of audit
procedures (AICPA, AU-C section 29).
If an auditor detects one or more of the
behaviors outlined above, he should pro-
ceed with a heightened level of professional
skepticism with respect to information pro-
vided by management and increase the reli-
ability of audit procedures used.
How Auditors Can Cope
The financial markets create enormous

23. pressure for companies to manage earn-
ings. At the same time, auditors are expect-
ed to be more vigilant than ever in carry-
ing out their responsibility to identify
misleading financial statements. Despite
repeated warnings about the long-term con-
sequences of managing quarterly and year-
end earnings, many businesses persist in
these behaviors to the detriment of the
entire financial system. The destructive ten-
dencies associated with a preoccupation
with earnings manipulation often mirror the
model developed by Schaef and Fassel in
their work with addictive organizations.
The model can help identify warning signs,
summarized in the Exhibit, which audi-
tors can use to assess the behavior patterns
of top management and the “tone at the
top.” While insight is not a panacea, an
awareness of the five behavioral charac-
teristics discussed in this article may be a
good first step in enhancing auditors’
efforts to assess the tone at the top. q
Susan S. Lightle, PhD, CPA (inactive), is
a professor of accountancy, and Bud Baker,
PhD, is a professor of management, both
at Wright State University, Dayton, Ohio,
and Joseph F. Castellano, PhD, is a pro-
fessor of accountancy at the University of
Dayton, Dayton, Ohio.
THE FIRST ANNUAL

24. CPA JOURNAL–ROSENBERG SURVEY
For the first time ever, The CPA Journal is teaming up with the
Rosenberg Survey team to offer
our readers a unique opportunity. For over 17 years, the
Rosenberg Survey has been
delivering the most in-depth and accurate financial
benchmarking survey of the accounting pro-
fession. Now we are bringing this national survey to New York
for the first time. Participants in
the 2015 CPA Journal–Rosenberg Survey will receive—
n The National 2015 Rosenberg Survey
n A customized sheet for N.Y. firms that compares your firm to
comparable firms
n A unique bonus survey of N.Y. CPA firms—only available to
participating readers.
The survey will allow N.Y. firms to benchmark themselves in
areas like fee growth, profitability,
billable hours, realization, gender, and dozens of other key
statistics.
By special arrangement, the fee for each firm to participate is
only $375.
A benefit to NYSSCPA members is the BONUS survey of only
N.Y. firms at no cost to them.
Go to www.rosenbergsurvey.com to get started. Remember to
enter promo code NY 2015
to make sure you receive all three surveys. For more
information, contact Charles Hylan at chy-
[email protected]
Full Disclosure: This is a special service to our readers. The
editors believe it is essential for
firms to understand their competitive environment and practice

25. growth areas. The CPA Journal
and NYSSCPA receive no compensation whatsoever from this
survey. A general summary of sur-
vey results will appear in our special issue on managing your
practice (MYP) later this fall, but
only participants will receive the full national survey,
customized comparison sheet, and bonus
survey.
Copyright of CPA Journal is the property of New York State
Society of CPAs and its content
may not be copied or emailed to multiple sites or posted to a
listserv without the copyright
holder's express written permission. However, users may print,
download, or email articles for
individual use.