Corporate Governance, Ethics, and Fraud Prevention Frameworks

Posted on Jan 29, 2026 in Business Administration and Management (BAM)

Corporate Governance and Ethical Foundations

Key Roles in Corporate Governance

Corporate governance defines how a company is directed and controlled through different roles:

• Shareholders are the owners who elect the Board of Directors.
• The Board sets direction, oversees management, and has a fiduciary duty to act in shareholders’ best interests.
• Management (CEO/CFO) runs daily operations and sets the Tone at the Top.
• The Audit Committee (a sub-group of independent board members) oversees financial reporting, internal controls, internal audit, and the external auditors.
• External Auditors are independent CPAs who provide assurance on the financial statements to investors and the public.

Ethical Culture: Tone at the Top

The Tone at the Top is the real message leadership sends through its actions and rewards. A strong ethical tone encourages honesty and speaking up, while a poor tone—focused only on hitting numbers, punishing bad news, and tolerating intimidation—creates a culture of fear and silence that significantly increases fraud risk.

Risk and Control Frameworks

The COSO Internal Control Framework focuses on policies and processes that give reasonable assurance about reliable financial reporting, safeguarding assets, effective operations, and compliance with laws. In contrast, COSO Enterprise Risk Management (ERM) takes a broader view of risks to the organization’s strategy and objectives, integrating risk considerations into decision-making across the whole business.

Stakeholder Theory and Ethical Collapse

The Triple Bottom Line asserts that a responsible company should care about people, planet, and profit, not just shareholder returns. This concept ties into stakeholder thinking versus a pure shareholder focus.

Jennings’ Seven Signs of Ethical Collapse

These signs describe patterns in companies heading for trouble:

1. Pressure to maintain the numbers.
2. Fear and silence.
3. Young, inexperienced employees and a bigger-than-life CEO.
4. A weak Board of Directors.
5. Conflicts of interest ignored.
6. A belief in “unique” innovation that puts the firm above normal rules.
7. Using good deeds in some areas to excuse bad actions in others.

A major theme is pressure to maintain the numbers—when leaders insist on meeting earnings targets at all costs, employees are pushed toward earnings management and fraud and are afraid to report bad news.

Whistleblowing and Group Ethics

DeGeorge’s Criteria for Ethical Whistleblowing

Whistleblowing is morally justified (or required) when:

• There is likely serious harm to the public or stakeholders.
• The employee has tried internal reporting channels.
• The employee has good evidence that wrongdoing is real.
• The employee has escalated appropriately (e.g., going above the immediate supervisor).
• The employee reasonably believes that going outside the organization can prevent or reduce the harm.

Group ethics and diffusion of responsibility are illustrated by the Parable of the Sadhu, where many people help a suffering traveler a little, but no one takes full responsibility for his safety. This shows that in groups, people often think “someone else will handle it.” Without clear ethical leadership and ownership, even decent people can make unethical group choices.

Governance and Ethics Case Studies

Lessons from Enron, Tyco, and ZZZZ Best

• Enron demonstrated extreme pressure to maintain the numbers, complex off-balance-sheet structures, a weak board and audit committee, and a toxic Tone at the Top, leading to massive fraud and collapse.
• Tyco involved executives misusing company funds for personal luxury, a board that failed to monitor or restrain them, and a culture that tolerated excess and conflicts of interest.
• ZZZZ Best was a seemingly successful company built on fake contracts and fraudulent operations, where governance and external auditors failed to perform adequate skeptical checks and verification.
• The Parable of the Sadhu serves as a case study on leadership and group ethics, illustrating how diffusion of responsibility allows groups to fail morally when no one person owns the ethical problem.

Auditing Standards and Professional Ethics

Core AICPA Principles of Professional Conduct

The core AICPA Principles define how professionals should behave:

• Integrity means being honest and doing the right thing even under pressure.
• Objectivity means avoiding bias and conflicts of interest.
• Due Care requires maintaining competence and doing careful, high-quality work.
• Independence (for audits and other attestation work) requires being free from relationships that impair impartiality in fact and appearance.
• Professional Skepticism means having a questioning mind and not accepting management’s explanations without sufficient appropriate evidence.

Separate audit reporting standards exist for AICPA (nonpublic entities) and PCAOB (public companies). Both require auditors to explain their responsibility to obtain reasonable assurance that the statements are free of material misstatement and to communicate appropriately with those charged with governance.

Auditor Responsibilities Regarding Fraud and Illegal Acts

Auditors must design and perform the audit to detect material misstatements caused by error or fraud. They have duties to investigate red flags, evaluate the impact of illegal acts, and report up to management and the Audit Committee. In some cases, auditors may need to consider withdrawing or reporting externally if serious issues are not addressed.

Fraud Frameworks and Risky Personalities

Fraud frameworks help explain why fraud occurs:

• The Fraud Triangle requires pressure or incentive (financial stress), opportunity (weak controls), and rationalization (self-justification).
• The Fraud Diamond adds capability, recognizing that the fraudster must have the skills, access, and position to commit and conceal the fraud.
• The Fraud Pentagon further expands the model by highlighting traits like competence and arrogance, especially in powerful executives who believe rules do not apply to them.

The Dark Triad of Personality Traits

The Dark Triad describes leaders who greatly raise the risk of unethical decisions and fraud:

• Narcissism: Craving status and admiration.
• Machiavellianism: Being manipulative and focusing on winning at any cost.
• Psychopathy: Lacking empathy or remorse, easily lying or exploiting others.

Maintaining Skepticism and Professional Judgment

Resisting Client Pressure and Using Technology

A crucial theme is maintaining skepticism when facing client management pressure. Ethical auditors must resist pressure to cut corners, accept weak evidence, or “just trust us.” Instead, they must insist on performing appropriate procedures, challenging aggressive accounting estimates, and obtaining independent corroboration, even if it strains the client relationship.

The use of AI and data analytics in auditing can help by scanning large datasets and highlighting unusual patterns, but AI tools cannot replace professional judgment. Auditors must still understand how the tools work, whether the data is reliable, and whether the results make sense in context. Auditors remain responsible for the final opinion.

Chapter 5 Case Studies: Failures in Control and Skepticism

• Rita Crundwell / City of Dixon showed massive long-term embezzlement enabled by weak internal controls, excessive trust in a single person, and auditors who failed to be skeptical.
• CliftonLarsonAllen illustrated independence failures, where auditors became too involved with clients, creating self-review and management participation threats.
• ZZZZ Best again demonstrated fraudulent reporting and weak auditor skepticism.
• Tyco showed how a dominant CEO with Dark Triad traits, combined with weak board oversight and insufficient auditor pushback, can lead to major ethical and reporting failures.

Understanding Earnings Management

Earnings management is the intentional use of accounting choices or real business decisions to shape reported earnings to meet targets (like analyst forecasts, debt covenants, or bonus thresholds) rather than simply reflecting the firm’s actual economic performance. The ethical concern is that even when a method is technically allowed under GAAP, it can still be misleading if the goal is to deceive users about performance or risk.

Judgment Versus Manipulation

Reasonable judgment uses estimates and choices to best reflect reality within GAAP. In contrast, manipulation uses those same tools primarily to hide poor performance or create a false picture, especially when management’s incentives depend on hitting certain numbers.

Key Types of Earnings Management

• Income Smoothing aims to reduce volatility and show a steady trend by shifting income or expenses between periods.
• Big Bath Accounting means taking very large write-offs or losses in a bad year, often when new management arrives, so that future periods look better by comparison.
• Cookie Jar Reserves involve recording excess reserves (e.g., for bad debts or warranties) in good times and releasing them later to boost earnings in weak periods.
• Premature Revenue Recognition records revenue before the earnings process is complete or before it is earned and realizable (e.g., recognizing sales before delivery or before performance obligations are met).

Materiality and Non-GAAP Financial Measures

Materiality has both quantitative and qualitative sides. A misstatement can be material because of its size, but also because it changes a trend (e.g., turning a loss into a profit), hides a regulatory violation, or affects key ratios or covenants. Thus, even small earnings management can be ethically serious.

Non-GAAP financial measures are adjusted numbers (like “adjusted earnings” or EBITDA) that start from GAAP but add back or remove items. They can help explain performance but are often used to make results look better than GAAP. They become misleading if they consistently exclude “bad” items without fair disclosure and reconciliation.

Case examples show how this plays out: Enron used aggressive revenue recognition and off-books entities to pump up earnings and hide debt; Green Mountain Coffee Roasters used optimistic guidance and accounting that concealed underlying issues; and HealthSouth used false entries and reserve games to hit earnings targets quarter after quarter, making it a classic example of earnings management escalating into outright fraud.

Ethical Leadership, Culture, and Fraud Risk

The Role of Ethical Leadership and Followership

Ethical leadership means leaders prioritize honesty, fairness, and responsibility above hitting earnings targets. Good leaders set a strong ethical tone, act consistently with their values, and encourage truth over pressure. Authentic leaders act from real values, and servant leaders put others first, using support instead of fear.

Employees also play a role through followership. Good followers use their own judgment, question wrongdoing, and act as moral agents, not hiding behind “I was told to.”

Company culture and reward systems shape behavior: people imitate what leaders reward. Rewarding honesty builds integrity, while rewarding aggressive results encourages earnings manipulation. Whistleblowing depends on whether employees feel safe; they report wrongdoing more when issues seem serious, when silence conflicts with their values, and when they believe leadership will not retaliate and reporting channels are trustworthy.

Toxic Leadership and the Toxic Triangle

Toxic leaders, especially those with narcissistic or bullying traits, create high fraud risk. The HealthSouth case illustrates this: CEO Richard Scrushy demanded that earnings always meet targets. When the company fell short, he pressured CFOs and accountants to “fix the numbers.” Many CFOs complied because Scrushy was authoritative, narcissistic, and intimidating—classic toxic leader traits. Followers became afraid of losing their jobs and were slowly pulled into a culture where fraud was normalized. This created the toxic triangle: destructive leadership, susceptible followers, and an environment of high pressure with weak ethical controls. Employees who wanted to act ethically felt trapped, and whistleblowing was unlikely because leadership made it clear that honesty was not rewarded. This case shows how a bad Tone at the Top and fear-based followership lead directly to massive earnings manipulation.

Culture, Rewards, and Ethical Drift (KPMG Case)

In the KPMG tax shelter case, the issue was selling aggressive, questionable tax shelters to clients. Leaders inside KPMG were rewarded based on revenue and profit, not ethical behavior, which encouraged partners to push products that the IRS later deemed abusive and misleading. The culture valued money over integrity, creating an environment where people justified unethical actions because “everyone else is doing it” and because leaders promoted those who brought in big fees. This case shows how reward systems shape behavior: when leadership celebrates results at all costs, employees mirror those priorities. It also shows failed ethical leadership—no one stepped up to slow the firm down or question whether the strategy was right, so the entire organization drifted into wrongdoing. This reinforces the need for leaders who set clear ethical expectations and followers who are willing to push back.

Behavioral Ethics and Decision Making

Blind Spots and Moral Disengagement

Research shows that ethical behavior depends on systems, not just good intentions. Mesmer-Magnus and Viswesvaran found that people are more likely to whistleblow when there are safe reporting channels, leadership support, and low fear of retaliation. Brennan and Kelly showed that auditors report wrongdoing more when the issue has high moral intensity and when they do not feel forced to act against their values.

In Bazerman’s Blind Spots, unethical behavior often happens without people realizing it. Key concepts include:

• Moral Disengagement: Allows people to justify wrong actions.
• Ethical Fading: Makes people stop seeing a situation as an ethical choice at all.
• Motivated Blindness: Occurs when we ignore wrongdoing because it benefits us.
• Incrementalism (the slippery slope): Explains how small unethical steps grow into major misconduct.
• Behavioral Forecasting Errors: Show that people think they will act ethically later but fail under real pressure.

Bazerman emphasizes that formal codes do not work unless a company’s culture and incentives truly support honesty. Reward systems, self-serving bias, and unconscious habits can quietly push people toward unethical decisions even when they believe they are acting fairly.