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Can honesty be legislated?

In 1820, English clergyman and author C.C. Colton wrote, "There are some frauds so well conducted, that it would be stupidity not to be deceived by them." Nearly 175 years later, we are frequently surprised by revelations of frauds so well-conceived that they have gone undiscovered for lengthy periods. And, yet, a conviction that fraud can be prevented by legislation apparently continues to prevail in certain circles. But this conviction is as unfounded as the conviction held by perpetrators that they can "get away with" their fraud forever.

FEI has long believed that good ethics are good business and has demonstrated this belief through the adoption of a code of ethics for members, the recommendation that members include in their company's annual report a management report on internal controls, and our participation as a member of the Committee of Sponsoring Organizations (COSO) of the National Commission on Fraudulent Financial Reporting (the Treadway Commission). The Treadway Commission recognized that there were varying interpretations and philosophies regarding an entity's internal controls. It recommended that the sponsoring organizations "work together to integrate the various internal control concepts and definitions and to develop a common reference point." According to the commission, this would "help public companies judge the effectiveness of their internal controls, and thus help public companies improve their internal control systems"

This fall, after nearly three years of work that included two exposure drafts, many comment letters, and countless hours of discussion with corporate CEOs, CFOs, academics, accountants, auditors, legislators, and regulators, COSO published its report, "Internal Control--Integrated Framework." The report defines internal control, describes its components and provides criteria against which an internal control system can be assessed. It urges corporations to report on their internal controls and it provides evaluation tools and guidance for use in evaluating the company's internal control system.

The report has met with generally favorable reviews. The Federal Deposit Insurance Corporation (FDIC), in proposed regulations to implement the FDIC Improvement Act of 1991, which requires banks to report on internal controls, stated that an example of acceptable internal control standards can be found in the COSO report. This recommendation has been strongly criticized by some individuals who seem to believe that honesty can be legislated.

Donald H. Chapin, assistant comptroller general of the U.S., has asserted that the COSO report "falls short of meeting the expectations of the Treadway Commission" and "in effect calls for a retreat from the public interest." Mr. Chapin's assertions have been strenuously refuted by Robert L. May, chairman of COSO and a former chairman of the AICPA. May and others believe that the General Accounting Office is intent upon requiring independent auditors to publicly report on a wide variety of internal controls. FEI strongly and successfully opposed such requirements when previously proposed by Representative Ron Wyden (D-OR).

The Treadway Commission identified the "tone at the top" as the most important factor contributing to the integrity of the financial reporting process. It said, "Notwithstanding an impressive set of written rules and procedures, if the tone set by management is lax, fraudulent financial reporting is more likely to occur." In several recent cases, fraudulent financial reporting is alleged to have been a result of fraud by the companies' top executives. Would legislating an auditor's report on internal control have prevented these frauds? Not likely!

Internal controls and the audit process, no matter how well designed and operated, are designed to provide "reasonable assurance" that the financial statements are free of material misstatement. C. C. Colton recognized the impediments to the detection of fraud in 1820. Those who seek honesty by legislation should recognize that today.
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Title Annotation:From the President
Author:Roy, P. Norman
Publication:Financial Executive
Date:Jan 1, 1993
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