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• An important study about top management overrides of internal control can be found at
www.aicpa.org/audcommctr/download/achilles_heel.pdf.
• Here is a short summary of the introduction to this study:
Even though internal controls over financial reporting may seem well-designed and
effective, they can be overridden by top management. Many financial statement frauds have
been committed by intentional senior management override of internal controls. Top
management override of internal controls is the Achilles‟ heel of fraud prevention.
Management is primarily responsible for the design, implementation, and maintenance of
internal controls. Therefore, the entity is always exposed to the hazard of management
override of controls. When the opportunity to override internal controls is combined with
powerful incentives to meet accounting objectives, top management may engage in
fraudulent financial reporting. Thus, otherwise effective internal controls cannot be relied
upon to prevent, detect, or deter fraudulent financial reporting perpetrated by top
management.
• So it makes little economic sense for SOX to require companies to make significant
expenditures to upgrade their internal controls, when the best internal controls on the planet
would not have prevented the major financial reporting scandals. Even a control system on
steroids can be overridden or bypassed by a corrupt top management.
• Very few employees will risk their jobs to defy a top management that is overriding or
bypassing internal controls.
• The major financial frauds were not due to weak controls. They were due to corrupt top
management overriding or bypassing internal controls by bullying or bribing lower-level
employees.
Conclusion: The SOX requirement for top management and the auditors of public companies to
report on internal controls would have done nothing to head off top management fraud before SOX
was enacted. It is very doubtful if it will be effective after SOX has been enacted. The recent financial
scandals have shown us:
• The dominance of powerful CEOs over weak boards of directors, as evidenced by
breathtakingly high CEO compensation.
• The vulnerabilities of internal controls when top management is corrupt.
• The ineffectiveness of audit committees.
• The reluctance of auditors to stand up to corporate crooks and to risk being fired from
large and lucrative audit engagements.
• The passivity of large stockholders, such as pension funds, mutual funds, and institutional
investors like insurance companies and investment houses, which could have major influence but
choose not to use it.
• The ineptness of government regulators.
In view of these considerations, it appears that some more enterprising approaches are needed to
improve the validity of financial reporting. Maybe we should think outside the box, and use some
carrots in addition to the sticks. Here are a few ideas:
• Fraudulent financial reporting inflates the financial statements, making them look better
than they really should look. That should attract the attention of corporate raiders and takeover
artists. But laws designed to prevent takeovers and unfriendly mergers have handicapped
corporate raiders and takeover artists. For example, the Williams Act requires any investor who
acquires 5% or more of a company‟s stock to file a report with the SEC. That alerts the target to