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CHAPTE R 3 Ethics, Fraud, and Internal Control 123

Appalling as this type of fraud loss appears on paper, these numbers fail to reflect the human suffering
that parallels them in the real world. How does one measure the impact on stockholders as they watch
their life savings and retirement funds evaporate after news of the fraud breaks? The underlying problems that
permit and aid these frauds are found in the boardroom, not the mail room. In this section, we examine
some prominent corporate governance failures and the legislation to remedy them.

THE UNDERLYING PROBLEMS. The series of events symbolized by the Enron, WorldCom, and
Adelphia debacles caused many to question whether our existing federal securities laws were adequate to
ensure full and fair financial disclosures by public companies. The following underlying problems are at
the root of this concern.
1. Lack of Auditor Independence. Auditing firms that are also engaged by their clients to perform non-
accounting activities such as actuarial services, internal audit outsourcing services, and consulting,
lack independence. The firms are essentially auditing their own work. The risk is that as auditors they
will not bring to management’s attention detected problems that may adversely affect their consulting
fees. For example, Enron’s auditors—Arthur Andersen—were also their internal auditors and their
management consultants.
2. Lack of Director Independence. Many boards of directors are composed of individuals who are not in-
dependent. Examples of lack of independence are directors who have a personal relationship by ser-
ving on the boards of other directors’ companies; have a business trading relationship as key customers
or suppliers of the company; have a financial relationship as primary stockholders or have received
personal loans from the company; or have an operational relationship as employees of the company.
A notorious example of corporate inbreeding is Adelphia Communications, a telecommunications
company. Founded in 1952, it went public in 1986 and grew rapidly through a series of acquisitions.
It became the sixth largest cable provider in the United States before an accounting scandal came to
light. The founding family (John Rigas, CEO and chairman of the board; Timothy Rigas, CFO, Chief
Administrative Officer, and chairman of the audit committee; Michael Rigas, Vice President for oper-
ation; and J.P. Rigas, Vice President for strategic planning) perpetrated the fraud. Between 1998 and
May 2002, the Rigas family successfully disguised transactions, distorted the company’s financial
picture, and engaged in embezzlement that resulted in a loss of more than $60 billion to shareholders.
Whereas it is neither practical nor wise to establish a board of directors that is totally void of self-
interest, popular wisdom suggests that a healthier board of directors is one in which the majority of
directors are independent outsiders, with the integrity and the qualifications to understand the com-
pany and objectively plan its course.
3. Questionable Executive Compensation Schemes. A Thomson Financial survey revealed the strong
belief that executives have abused stock-based compensation. 14 The consensus is that fewer stock
options should be offered than currently is the practice. Excessive use of short-term stock options to
compensate directors and executives may result in short-term thinking and strategies aimed at driving
up stock prices at the expense of the firm’s long-term health. In extreme cases, financial statement
misrepresentation has been the vehicle to achieve the stock price needed to exercise the option.
As a case in point, Enron’s management was a firm believer in the use of stock options. Nearly ev-
ery employee had some type of arrangement by which he or she could purchase shares at a discount
or were granted options based on future share prices. At Enron’s headquarters in Houston, televisions
were installed in the elevators so employees could track Enron’s (and their own portfolio’s) success.
Before the firm’s collapse, Enron executives added millions of dollars to their personal fortunes by
exercising stock options.
4. Inappropriate Accounting Practices. The use of inappropriate accounting techniques is a characteristic
common to many financial statement fraud schemes. Enron made elaborate use of special-purpose enti-
ties to hide liabilities through off-balance-sheet accounting. Special-purpose entities are legal, but their
application in this case was clearly intended to deceive the market. Enron also employed income-inflat-
ing techniques. For example, when the company sold a contract to provide natural gas for a period of
two years, they would recognize all the future revenue in the period when the contract was sold.

14 H. Stock, ‘‘Institutions Prize Good Governance: Once Bitten, Twice Shy, Investors Seek Oversight and Transparency.’’ Investor
Relations Business (November 4, 2002).