Independence – The Key to Internal Control

How to Make Controls WorkAn old joke goes something like this…  A businessman was interviewing applicants for the position of Divisional Manager.  He devised a simple test to select the most suitable person for the job. He asked each applicant the question, “What is two and two”?

The first interviewee was a journalist. His answer was “twenty-two.”  The second applicant was an engineer. He pulled out a calculator and showed the answer to be between 3.999999 and 4.000001.  The next person was a lawyer. He stated that in the case of Jenkins v. Commr of Stamp Duties (Qld), two and two was proven to be four.

The last applicant was an accountant. The business man asked him, “How much is two and two?” The accountant got up from his chair, went over to the door, closed it then came back and sat down.  He leaned across the desk and said in a low voice, “How much do you want it to be?”   He got the job.  Unfortunately, this joke is sometimes far too close to the truth!

Lack of accounting independence is at the root of the accounting, management and Wall Street scandals of the last several years and longer.  How can the public trust the leadership of public companies to serve shareholder interests when “dependant relationships” are aimed at serving insider interests?  Without this public trust, our economic system is in peril.

The fixes in Washington do not go far enough  – politics, special interests and campaign financing still hold sway.  Board independence is part of the solution but accounting independence is the key. Without accounting independence, transparency in corporate affairs and fair and objective financial reproting can not be guaranteed.

Accountants are the corporate score keepers.  The key to reform is insuring the fairness, accuracy and objectivity of the information they provide.  The problem is that accountants are often not independent.  They are therefore not objective and they are not incentivized to provide fair and accurate information to those outside of the corporate “in group.”

External auditors are more objective, but sadly they too are easily influenced, since management usually participates heavily in their engagement and compensation. Even if auditors were totally independent, it would not be enough, since their role is to essentially second-guess judgment calls made by company accountants.  It’s as if they were trying to call balls and strikes from third base while the home plate umpire (the company’s Chief Accounting Officer) is working for only one team — the insiders.  Outside investors (the other team) cannot be assured of accurate and timely calls from the umpire because the CAO and other company insiders are able to manipulate the score for their own ends.

In this game, the Board is not part of the Corporate “in group” either.  They are in the dark as much as investors, debt holders and the public.   Suprisingly, many Board members like it that way because it absolves them of responsibility.  Not to mention the fact that many Board members are insiders in their own companies with a vested interest in the system remaining the way it is.  To change would mean they too might lose control of their company scorekeeping and their own perfomance measurement.

So what does the public need to understand given this state of affairs?  If they think corporate insiders are able to cheat them with impunity… they are right.  If they think they can’t alsways trust company financial statements … they are right!  If they think Boards are sometimes working for insiders and not for shareholders or the public … they are correct. But If they want to fix the system, they must take scorekeeping (accounting) away from the insiders.

It is just common sense that insiders should not control thier own scorekeeping and performance measurement.  It is an essential tenet of internal control that recordkeeping must be kept seperate from those who make decisions and control the assets.  It’s called “seperation of duties” — the most basic principle of internal control.

One fundamental reason is because accounting is not black and white (despite most people’s beliefs) … It’s mostly gray … It’s a series of judgment calls!  The majority of accounting decisions require the judicious evaluation of risks and future costs and potential revenues thus falling squarely into the field of judgment NOT black and white rules.  Fair and objective accounting, therefore, can only happen when the accountants themselves are fair and objective … free of biases … in other words independent.

Radical though this reforms may seem to those who would wish to preserve the status quo, it is the only way to insure full fair and transparent corporate financial reporting.  It is the only way to insure public confidance in our financial system.  And it is the only way to avoid economic booms and busts most frequently caused by insider proclivity to ignore or under-report serious financial risks during boom times, because it serves their financial interests to do so.

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Why Controls Don’t Work

Capture12-18-2013-7.47.06 PMWhat happens when a company fails or a major fraud occurs or financial statements are false and misleading?  How do these things happen or — why don’t internal controls work?

There are three reasons why internal controls don’t work:

1. The control doesn’t exist.

2. The wrong thing is being controlled.

3. A different (competing) control exists.

Controls are pocesses or activities designed to accomplish an objective (or avoid a risk).  If the objective (or risk) isn’t recognized and their is no process to accomplish the objective (or prevent the risk), then the control doesn’t exist.  For example, “We trust our CEO” or “CFO” or “Division President to do the right thing”  is not a control.  If that individual decides to do the wrong thing — then no control exists to prevent it from happening.

At other times, the wrong thing is being controlled.  For example multiple controls may exist at lower levels in  the organization to insure fair and accurate financial reporting.  But if a senioir executive (CEO, CFO, etc)  can manipulate financial information without being challenged then controls at the lower levels are pointless — the wrong thing is being controlled.

Finally, a different or competing control may be the reason a control doesn’t work.  In this instance the organization may be aggressively and tightly controlled but for the wrong reason.  Often an autocratic executive may have an organization firmly under control.  When that executive says “jump,” everyone jumps,  But that control may not be aimed at the correct objectives.  If the executive decides to profit personally at the expense of the organization, shareholders, employees or other constituents then competing control(s) exist which prevent the desireable objective(s) from being met.

For controls that work — ask these three basic questions:

1. What risk being addressed or objective of the control?

2. Is there a clear process or procedure that provides concrete assurance that the risk will be avoided or the objective met?

3. Do competing controls or objectives exist that might cancel out the control?

If you can answer these three questions with clarity and confidence then you have internal controls that work.

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Detailed references are available from the following 21 individuals at: 

Denis Nally – Chairman & CEO, PricewaterhouseCoopers – US Firm

Joel Gordon – Chairman, HealthSouth Corp.

Jay Grinney – CEO & President, HealthSouth Corp.

Don Southwell – CEO & President, Unitrin Corp.

Tom Patterson – CEO, Daxco, Txen, SEAC

Lee Hillman – Audit Committee Chairman, HealthSouth Corp

John Markus – EVP & Chief Compliance Officer, HealthSouth Corp.

Ed Blechschmidt – Audit Committee Chairman, HealthSouth Corp

Gary McCausland – President, Dominoes Pizza

Philip Besch – CFO, Hagemeyer, Estee Lauder, J.M.Huber

Achim Knust – CFO/Director, Black & Decker, Lexmark, Emhart

Matt Budd – Managing Partner, Financial Executives Consulting Group

Tom Trimmer – Partner, PricewaterhouseCoopers

Andy Trott – EVP J.M.Huber Corp

Ralph Thomas – Executive (retired) US Steel Corp

Jay Haberland – VP Audit & Acting CFO, United Technolgies, Black & Decker

Clay Edwards – VP Audit Interpool Corp.

Kevin Jackson – Director Audit, Sanmina-SCI Corp

Bob Dalton – Director Audit, Schering Plough

John Mcnamara – Director Audit, McGladrey & Pullen

To see these references visit


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Koexco – Control Excellence

Koexco is dedicated to the idea that control excellence means controls that are not only effective but also highly cost effective.  In fact excellent internal controls boost productivity and profitability significantly beyond their cost.

This requires eliminating redundant and excessive controls and insuring that remaining controls address significant risks — financial and operational.

It also implies that all significant risks have been identified, quantified and cost effectively controlled with appropriate measures.

Effective auditing is the the process of identifying and prioritizing key risks together with establishing and testing the effectiveness and cost effectiveness of related controls.

The above principles are the foundation of Koexco’s approach to auditing and control.


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