Corporations must exercise internal control if they want to avoid the sort of fraudulent financial reporting that prompted federal investigations into corrupt business practices, five leading accounting organizations said in a study released Tuesday.
The key to maintaining control is a combination of "integrity, ethical values and competence" that "must start with the chief executive and senior management, and permeate the organization," according to a draft report by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO.
The Treadway Commission -- named for its chairman, former Securities and Exchange Commission head John Treadway -- was a private-sector attempt to find ways to prevent fraudulent financial reporting like that uncovered in the mid-1980s by the House Subcommittee on Oversight and Investigations, chaired by Representative John D. Dingell, D-Mich.
Information provided by the Dingell committee led to inquiries by the Labor Department into whether the now-defunct securities firm Drexel Burnham Lambert Inc. had defrauded pension funds, as well as to criminal investigations of the activities of Northrop Corp.
For years afterward, "there was a lot of discussion" about whether more internal controls would have prevented the fraud, "but there was no common understanding about what internal control really meant," said Robert L. May, chairman of the COSO and former chairman of the American Institute of Certified Public
Accountants, one of the five sponsoring organizations.
The draft report, a product of 18 months of interviews, workshops and polling conducted by the national accounting firm of Coopers & Lybrand for the COSO, attempts for the first time to define the concept of internal control and set guidelines for its use in businesses, Mr. May said.
An internal control within a business can be as simple as a policy that the manager who has authority to approve an expenditure cannot have control over the business' cash box, or as complicated as the process by which a board of directors approves a corporate budget, Mr. May said.
Of the nine separate components that the draft report identifies as crucial to effective internal control, integrity and competence are most important, Mr. May said.
"Without those, the rest of the system won't stand," he added.