Lee Clarke Dean

Critical Perspectives on Accounting 19 (2008) 677–711
The dominant senior manager and the reasonably

careful, skilful, and cautious auditor
T.A. Lee a , F. Clarke b,c , G. Dean c,∗
a Emeritus Professor of Accountancy, the University of Alabama,
Honorary Professor of Accounting, University of St Andrews,
United States
b Honorary Professor of Accounting, The University of Sydney,
Emeriturs Professor of Accounting, The University of

Newcastle, Australia
c Professor of Accounting, The University of Sydney, Australia
Received 28 August 2006; received in revised form 11 November 2006; accepted 26 December 2006
Abstract
This paper examines a paradox in corporate audit history that threatens the credibility of the
current audit as a means of protecting stakeholders from corrupt senior managers. Using a histor-
ical analysis of legal cases of fraudulent reporting and subsequent public accountancy responses,
the study reveals the paradox of a corporate auditor denying or limiting responsibility to detect
material accounting misstatement (MAM) facilitated by dominant senior managers (DSM), while
relying on the honesty of senior managers. The primary finding of the legal case analysis is the
persistent presence of a DSM or team of DSM in the context of various contributing features, and
the creation by Victorian lawyers of a model of excuses for the corporate auditor. The primary
finding from the responses of public accountants is, within the context of the model of excuses
and the assumption of managerial honesty, continuous denial, or limitation of auditor responsibil-
ity for detecting MAM facilitated by DSM. The consequence of this history is that DSM intent
on MAM currently face corporate auditors generally untrained to assess the audit risk of manage-
rial domination facilitating MAM. The paper’s single recommendation is that corporate auditors be
educated and trained to assess the audit risk associated with DSM facilitating MAM. The paper’s
contribution to corporate auditing is its use of historical analysis to bring together previously
∗ Corresponding author. Tel.: +61 2 93513107.

E-mail address: g.dean@econ.usyd.edu.au (G. Dean).
1045-2354/$ – see front matter © 2007 Elsevier Ltd. All rights reserved.
doi:10.1016/j.cpa.2006.12.001
678 T.A. Lee et al. / Critical Perspectives on Accounting 19 (2008) 677–711
known but relatively disparate matters into a coherent whole that signals a fatal flaw in existing
practice.
© 2007 Elsevier Ltd. All rights reserved.
Keywords: Corporate auditing; Corporate financial reporting; Dominant senior managers; Material accounting
misstatement; Model of excuses
1. Introduction
We examine a paradox in the history of corporate auditing in which the auditor relies
on the honesty of senior managers while denying or limiting responsibility for detecting
material accounting misstatement (MAM) facilitated by dominant senior managers (DSM).
Our evidence demonstrates that MAM by DSM is a pervading feature of audit history. It
is evident in periods lacking an audit requirement as well as when there were mandatory
provisions. It appears irrespective of whether the auditor was an unskilled and dependent
representative of shareholders or a skilled and independent professional expert. MAM by
DSM affects relatively small companies as well as multi-national conglomerates. It has been
a persistent feature of corporate collapses and a continuous drain on corporate resources
since the mid nineteenth century. MAM by DSM reflects the willingness and capacity of
senior managers to use their influence to go beyond the legitimate activities of entrepreneur-
ship and risk-taking and enter the illegitimate area of deceitful behaviour. Also throughout
the history of corporate auditing, it is evident that public accountants have adopted a model
of excuses to deny or limit their responsibility for detecting MAM by DSM while creating
an image of a reasonably careful, skilful, and cautious auditor at work.
The historical evidence reveals the unwillingness of nineteenth century public accoun-
tants to even provide guidance on the matter, the consequential creation from legal judgments
of a model of excuses not to assume responsibility, and a more recent strategy of doing
“nothing” to address the general issue of fraud detection.1 Consequently, a continuous
expectations gap separates public accountants unwilling to accept primary responsibil-
ity for detecting MAM (unless it is separately contracted as a consultancy service), and
members of the public (including capital market participants, regulators, and legislators)
expecting auditors to detect such matters. It has become a situation with a paradoxical sta-
tus because courts and the public accountancy profession have continuously promoted the
notion of auditors trusting the honesty of corporate senior managers in relation to financial
reporting.
Our leitmotif is to examine with a historical lens the paradoxical issue of the corpo-
rate auditor’s responsibility for detecting MAM by DSM and identify a credible solution.
A timeline of selected legal cases and public accountancy responses from 1844 to the
present day is outlined and its main characteristics explained and discussed. The time-
line is predominantly British in the initial decades and then broadens to include the US
1 The strategy of doing “nothing” refers to a predilection to appear to respond to issues by instituting inquiries
and producing reports that, in effect, do not alter the status quo (Fogarty et al., 1991).
T.A. Lee et al. / Critical Perspectives on Accounting 19 (2008) 677–711 679
and Australia.2 The analysis identifies the continuous association of MAM with DSM –
either directly or as signalled in red flag warnings3 – and the damaging paradox of reliance
coupled with denial or limitation. It leads to a recommendation that the auditor should
assume a primary responsibility for detecting MAM by DSM in order to provide a cred-
ible opinion on the quality of accounting numbers reported by the latter. Acceptance of
this responsibility, however, leads to consideration of the current competence of corpo-
rate auditors to conduct the function of detecting MAM by DSM with independence and
objectivity, especially in the context of complex organisational structures combined with
impenetrable financing arrangements. The need to re-orientate existing educational and
training programs of public accountants to achieve such competence and independence is
discussed.
Much of what is presented as historical evidence in this study has appeared in other
studies of corporate auditing. However, what is unique to this study is the use of histor-
ical analysis to bring together previously researched evidence into a coherent whole that
demonstrates a fatal flaw in existing practice, i.e. despite being sufficiently competent to
understand MAM when it has been detected, the corporate auditor generally is insufficiently
educated and trained to identify DSM with potential to perpetrate MAM. In this respect, the
paper is concerned with the corporate auditor and DSM rather than the corporate auditor
and MAM.
2. Accounting misstatement and dominant managers
Before proceeding to the analysis of cases and responses, it is necessary to state the
parameters of the study. This is important with respect to the terms MAM and DSM.
MAM is a term used to denote deliberate accounting actions authorised by senior corporate
managers to deceive shareholders and other users of financial statements by manipulating
reported accounting numbers beyond what is legitimate within prescribed or accepted
accounting standards. Such manipulations include dubious and fictitious accounting entries
and adjustments designed to hide misappropriation of assets, mismanagement of resources,
imprudent or risky investment, crippling debt, and excessive or deficient profitability (see
Argenti, 1976; Klein, 2003; Sacks, 2004; Teo and Cobbin, 2005; Waddock, 2005; Woolf,
1982). It is not intended to include misappropriation of assets by non-managerial employees
or junior managers. DSM is a term that indicates directors and senior executives who use
their position of authority to cross accepted boundaries of risk-taking and decision-making
to initiate and manage the process of MAM. Such actions include overriding internal
controls, coercing employees and junior managers, and seeking compliance of external
service providers such as banks and lawyers. The overall objective of MAM by DSM is
to alter the provision of a true and fair view or fair presentation of a company’s financial
results (Clarke et al., 2003, p. 319–21).
2 The geographical limitations of the study are acknowledged.

3 Red flag warnings of MAM relate to indicators observed by corporate auditors in situations where misstatement
has taken place (e.g. Albrecht and Romney, 1986; Heiman-Hoffman et al., 1996; see also AICPA, 2002; Beasley
et al., 1999; Ramos, 2003).
We therefore argue that MAM occurs because of DSM and that the two matters are
essentially characteristics of the same phenomenon in corporate financial reporting. MAM
is highly unlikely to exist without DSM. This does not mean, however, that the existence
of DSM automatically signals the existence of MAM. Instead, we argue that MAM is more
likely to occur in the presence of DSM rather than in their absence. More specifically, MAM
is likely to occur with DSM in association with other contributing factors identifiable from
the historical analysis that follows.
We also contend that MAM by DSM takes place for different reasons, e.g. because of
either the greed of DSM with respect to contractual incentives or a mistaken belief that
purportedly short-term MAM is in the best long-term interests of the company. Whatever
the motivation, however, we argue that MAM by DSM has potential to damage significantly
a company and its shareholders and other stakeholders and that, for this reason, it is
necessary that corporate auditors not only assume a primary responsibility for detecting
it but also accept a need to develop sufficient competence to undertake such a governance
function successfully.
From the foregoing explanations, it is evident that the paper is not about two separate
topics, i.e. senior managers who dominate and the audit profession’s general responsibility
for fraud detection. Instead, we conflate these issues in the specific context of detecting
MAM by DSM. Although there have been numerous contributions to the business literature
about individual DSM (e.g. Arnold and McCartney, 2004), and there is a profusion of
contributions to the audit literature on fraud detection responsibility (e.g. Humphrey et al.,
1993), we believe this paper is unique in its drawing together of MAM and DSM. The paper’s
main contribution is therefore to provide a focus on the corporate auditor’s responsibility
for MAM by DMS in order to provide an effective audit.
3. 1844–1868
The Joint Stock Companies Registration and Regulation Act 1844 (7 & 8 Victoria, c.110)
was the first legislation permitting incorporation of companies by registration. It allowed
unlimited liability only and required companies to produce an audited annual balance sheet.
The act was silent on auditor qualifications (Hein, 1978, p. 148). In practice, he was typi-
cally a non-accounting shareholder elected by shareholders.4 The Joint Stock Banking Act
of 1844 (7 & 8 Victoria, c.113) had similar requirements for banks, and in 1855 the Limited
Liability Act (18 & 19 Victoria, c.133) permitted incorporation of companies with limited
liability for the first time. The following year, the Joint Stock Companies Act 1856 (19
& 20 Victoria, c.47) replaced the 1844 and 1855 Acts and removed the balance sheet and
audit requirements of the 1844 Act. The 1856 Act contained model articles of association,
including voluntary provisions for financial statements and audit. These included the pos-
sibility of the auditor not being a shareholder (Hein, 1978, p. 150; see also Ramage, 1982).
Although public accountants existed at this time, they do not appear to have commented on
these financial reporting and auditing arrangements, and thus inadvertently contributed to
the persistent problem of determining auditor responsibility for detecting MAM by DSM.
4 Maltby (1999) describes the late nineteenth century transition from lay to professional auditors in the UK.
3.1. Railway king
Consistent with the economic and political laissez-faire philosophy of the time, the
change in 1856 to a more lax corporate regulatory regime, in which government wished
companies “to manage their own affairs” (Hein, 1978, p. 149), took place shortly after the
1849 discovery of a major fraud in the burgeoning railway industry (Arnold and McCartney,
2004; McCartney and Arnold, 2000).5 The fraud affected the Eastern Counties Railway
Company (ECRC) and concerned George Hudson, the “Railway King.” Hudson inherited
£30,000 in 1827 and invested in railway companies. By 1849, he controlled four major
railways covering more than one-third of the UK network. He was an effective promoter of
railways but a bad manager with little comprehension of corporate governance—preferring
not to delegate to subordinates, taking primary decisions without regard to other directors
and, more generally, choosing compliant rather than competent employees. It was claimed
that Hudson bribed Members of Parliament to obtain governmental permission to extend his
railway lines and used his position as Member of Parliament for Sunderland to argue against
railway regulation. In 1849, his unscrupulous managerial and financial practices became
public. These included falsification of profits, use of insider information to manipulate the
ECRC share price, and sale of railway land he did not own. Hudson admitted his corruption
and was eventually jailed in 1865 for failure to repay his defrauded shareholders. Despite
this record, he was publicly applauded as a model entrepreneur by leading politicians on his
death. In this paper, however, Hudson is given as an early example of a DSM who crossed
the line between legitimate business practice and fraudulent activity in an unregulated
environment. In addition, he used contestable accounting practices – some would argue
MAM – as a regular part of his business practice.
3.2. North British Railway Company
Hudson was not the only Victorian railway entrepreneur to abuse his managerial position
and rely on MAM. The exposure of a major railway fraud in 1866 eventually led to general
legislation to regulate UK railway companies (Vamplew, 1974). There were also several
Acts of Parliament related to what subsequently were known as “regulated” industries (see
Jones, 1995). The financial performance of the North British Railway Company (NBRC) –
formed in 1842 and one of the largest Scottish companies of its time – was poor until the
appointment as chairman of Richard Hodgson, Member of Parliament for Northumberland.
Reported financial results improved considerably until, in 1866 and following a shareholder
investigation of concerns about the NBRC financial statements, a complex accounting fraud
was revealed involving inflation of sales, understatement of operational expenses, and failure
to depreciate capital expenditure.6 Actual profits were non-existent and dividends had been
paid out of capital in order to meet stock market expectations. Evidence from the 1866
investigation reveals how Hodgson overrode any internal controls that existed in NBRC,
instructed the company’s accountant to make entries necessary for MAM, and hid the
deception from his fellow directors. There was no audit of the accounting records because
5 See also Valance (1955, p. 66–78).

6 Arguably, this was not a fraudulent practice at the time (see Edwards, 1989, p. 109–25).
the Companies Act 1856 had removed the mandatory requirement of the 1844 Act. Whether
an audit would have discovered Hodgson’s fraud is debatable—particularly when most
shareholder audits at the time were by non-accountants. This was a time when the court
in the Nicol’s case (3 D G & I 387, 441) in 1859 decided that an auditor could be held
responsible for not detecting MAM—but only in circumstances where it was discoverable
(Teo and Cobbin, 2005, p. 40). This raised related issues of what could be discovered by a
non-accountant auditor, and what protection shareholders had in the absence of an auditor.
Later judgments characterised frauds as “ingenious” and “carefully-laid schemes” in order
to limit auditor responsibility, e.g. the Kingston Cotton Mill case (Chandler and Edwards,
1994a, p. 160). In a period of economic laissez faire, NBRC reveals the consequences of
the lack of adequate financial reporting, auditing, and corporate governance.
4. 1868–1900
The Regulation of Railways Act 1868 (31 & 32 Victoria, c. 119) was the British govern-
ment’s response to MAM as in NBRC. The act introduced some uniformity to accounting
disclosure by railway companies and required them to file annual financial statements with
the Board of Trade. However, there was no audit provision. This unverified approach to
financial reporting was also used in “regulated” industries such as life insurance, building
societies, electricity, and gas (see Jones, 1995). The only exception was banking. The 1879
Companies Act (42 & 43 Victoria, c.76) required an audit for banks as a result of the failure
of the City of Glasgow Bank (CGB) in 1878.
4.1. City of Glasgow Bank
The CGB court-appointed trustees reported a capital deficit of £6.2m compared to a

reported £1.6m surplus four months earlier. This was due to a fraud committed over a num-
ber of years.7 It involved fictitious accounting entries to understate assets and liabilities,
overvaluation of banking assets and investments, and hidden purchases of bank shares to
maintain its market valuation. The CGB suffered losses in a previous bank failure, lent
to business ventures with little hope of recovery, and made several imprudent investments
overseas. Despite concern within the Scottish banking community about the bank’s man-
agement, nothing was publicly said or done about it because of the considerable reputation
of the directors and secretary. The directors included the bank’s manager, Robert Stronach,
and its chairman, Lewis Potter. All were charged with preparing and publishing fraudulent
balance sheets between 1876 and 1878.
Founded in 1839, the CGB rapidly expanded and, by 1878, had over 1200 shareholders.
Many of these shareholdings represented the modest savings of middle-class Scots and
hundreds of families were ruined by the collapse. The effect of the failure was felt throughout
Scotland and the remainder of the UK economy. Stronach and Potter were found guilty of
direct involvement in the MAM, and the other five directors and secretary of knowingly
7 This account draws primarily upon Couper (1879) and Wallace (1905).
publishing false statements. All were imprisoned and the case resulted in a Parliamentary
debate. As noted previously, in 1879, a Companies Act was passed requiring banks to publish
annual audited balance sheets. However, auditors were not required to be professionally
qualified public accountants.
The CGB case reveals the DSM as a team that coerced junior managers into making
fraudulent accounting entries. Powerful corporate executives and directors were able to
report false accounting numbers to shareholders and the latter (and other stakeholders such
as employees) were severely damaged as a consequence.
4.2. Uncertainty about auditor’s responsibilities
The CGB case occurred at the beginning of a period of considerable uncertainty and
debate over the extent to which the auditor could be held responsible for the detection
of MAM (Chandler, 1997; Chandler and Edwards, 1996; Maltby, 1999; Teo and Cobbin,
2005). The period was one in which the public accountancy profession established its
institutions and became pre-occupied with protecting them from various challenges.8 Thus,
at a time when the UK corporate sector and its stock markets expanded in size and economic
importance, the need for publicly available and reliable financial information increased,
and MAM became frequent, public accountants focused on other matters. Exacerbating
this situation was the fact that nineteenth century shareholdings predominantly belonged
to family members or local business connections whose information needs arguably were
met by “insider” approaches to senior managers (Maltby, 1999, p. 33–5). Needs of smaller
outside investors were therefore growing and unaddressed.
Unsurprisingly in this regulatory vacuum, much was left to legal counsel and judges to
argue for and determine the boundaries of acceptable accounting and auditing procedures
and responsibilities in specific circumstances (Chandler, 1997; Chandler and Edwards,
1996; Maltby, 1999; Teo and Cobbin, 2005). Reliance on legal thinking, however, did not
always result in consistent decisions or opinions regarding permissible dividends and capital
maintenance (Maltby, 1999, p. 35–7), perceptions of careful and skilful auditing (Chandler,
1997, p. 64–70), and audit responsibilities (Teo and Cobbin, 2005, p. 40–5). In addition,
the main public accountancy bodies had not developed institutional mechanisms capable
of responding to public criticisms of accounting and auditing, and individual practitioners
were either reluctant or had minimal means of expressing their views.
In other words, between 1856 and 1900, widespread use of amateur shareholder audits,
absence of general legal requirements for audit, reliance on inconsistent legal interpretations,
and relatively silent institutions of public accountancy, combined to create a climate of
uncertainty regarding the auditor’s responsibility for detecting MAM facilitated by DSM.
Gradually, however, individual public accountants began to lay claim to audit competence
in the absence of regulation and professional guidance (Maltby, 1999, p. 37–46). This was
done in a number of ways, but the overall strategy was to project a profession of business
advisors competent to guide senior managers on matters such as share promotions and
dividend distributions. In addition, public accountants had to respond to public criticism of
8 See Kedslie (1990) and Walker (2004).

the quality of corporate auditing—even though they were not employed as auditors in the
cases concerned.
4.3. Model of excuses
Chandler and Edwards (1994a) provide an anthology of reports of significant late nine-
teenth century court cases involving the auditor and MAM. The judgments in these cases
reveal the parameters of responsibility set by judges in the absence of public accountancy
guidance or legislative mandate. In addition, Chandler and Edwards (1994b) provide an
anthology of contributions on the same issue to The Accountant of the same period. The
combination of articles, letters, conference proceedings, and editorials was engineered by
the journal’s editor to provide a voice for the public accountancy profession to clarify its
position over audit responsibilities. The contributions included criticisms reproduced from
non-accounting publications as well as writings by public accountants in response (Chandler
and Edwards, 1994b, p. xix). Using the two anthologies to provide supporting evidence,
we contend that a combination of court judgments and public accountants’ responses to
criticism created a model of excuses in the 1880s and 1890s with respect to the auditor’s
responsibility for MAM, and that this model persists to the present day.9
4.4. Judicial decisions and accountants’ responses
Between 1884 and 1900, a number of court decisions relating to the auditor’s responsi-
bility for detecting MAM emerged. They include the Leeds Estate, Building and Investment
Company (1887), London and General Bank (1895), Kingston Cotton Mill (1896), and
Irish Woollen Company (1900). These and other judicial statements effectively restricted
the work of the corporate auditor within a ring-fence containing accounting records and
financial statements (predominantly the balance sheet). In effect, these judicial statements
distanced the auditor from senior managers, even in situations where DSM were identified
as reasons for MAM, e.g. as in the Leeds Estate and Kingston Cotton Mill cases (Chandler
and Edwards, 1994a, p. 40 and 152).
The construction of this ring-fence involved various arguments. For example, the audi-
tor’s duty was to check the accounting records and the facts contained therein and not to
question the honesty of senior managers (Chandler and Edwards, 1994a, p. 45 and 142).
Alternatively, it was neither the responsibility of the auditor to tell senior managers how
to manage the company or what decisions to make (102, 138, and 142). In particular, the
auditor was to ensure the contents of the balance sheet agreed with the underlying account-
ing records (52). One judge reflected on uncertainty for the auditor regarding how far he
should go beyond checking the accounting records with the balance sheet (96). However,
the audit was not to be conducted in a mechanical way by merely checking the arithmetical
accuracy of the records and statements (192).
There were other judicial statements that reinforced this legal cordon around the corporate
audit function. For example, in order that the auditor could be held liable for failure to detect
9 The term model of excuses is used to denote credible reasons to excuse public accountants from the primary
responsibility for detecting MAM by DSM, while continuing to offer the service as a separate management service.
MAM, certain conditions had to be considered. First, suspicions of MAM were aroused
and ignored (Chandler and Edwards, 1994a, p. 69, 138, 160, 193, and 195). Second, these
suspicions depended on circumstances surrounding MAM (138 and 159). Third, reasonable
care (skill, caution, and diligence) was absent (138, 156, 157, 159, 160, 169, 170, and 191).10
Taken together, these statements created considerable flexibility for public accountants with
respect to responsibility for MAM detection because they ensured that the general standard
with which they could be judged was considered on a case by case basis. In particular, they
effectively signaled to the public that detecting MAM facilitated by DSM was not a matter
reducible to the auditor following prescribed rules (Chandler and Edwards, 1994a, p. 201).
This was consistent with the dictum in the London and General Bank case that the auditor
was not an insurer against MAM (Chandler and Edwards, 1994a, p. 138 and 191).
The impact of court cases relating to MAM in the late nineteenth century created regular
criticism of the worth of the corporate audit to shareholders. In response, public accoun-
tants supplied a series of arguments to excuse their failure to detect MAM. These statements
took various forms but captured judicial statements of the time. The most popular excuses
were complaints that audit fees were too small to provide effective auditing (Chandler and
Edwards, 1994b, p. 1, 6, 10, 33, 39, 41, 42, 48, 87, 116, 124, 126, 131, 153, 159, 177,
181, 202, 252, 255, 273, 301, and 303), and there was insufficient time before reporting to
permit the detection of complex MAM (16, 19, 39, 41, 42, 52–3, and 252). Within the fee
complaint there was some recognition by public accountants that, once accepted, the audit
engagement should not be restricted merely because the fee was inadequate (1, 48, 126, 202,
and 252). Nevertheless, the impression was given by public accountants that shareholders
should not expect complete protection against MAM because of fee and time constraints.
The comments about fees by individual practitioners reinforced similar comments in court
cases (Chandler and Edwards, 1994a, p. 10, 72, and 148). Their significance in the context
of this paper is that they would not be out of place in current times when public accountants
regularly protest their inability to assume detection of MAM as a primary audit objec-
tive because of the high costs and length of time that would be needed, i.e. “lowballing”
competitive-nature arguments (DeAngelo, 1981).
Practitioners and the editor of The Accountant also argued for the restriction of audit
responsibility on grounds frequently used by counsel in court cases of the day. Indeed, most
of their comments in this respect appear to mimic statements by lawyers. It was argued that
the auditor should be held responsible only for verifying “facts” as in accounting records
(Chandler and Edwards, 1994b, p. 42, 88, 111, 125, 128, 131, 137, and 156) and exercising
reasonable care and skill within specific circumstances (86, 93, 125, 128, 152, 201, 202,
227, 252, 255, 256, 258, and 299). However, there were other excuses not apparent in case
law, many of which were directed at shareholders. The latter’s desire for speedy investment
returns, disinterest in supervising managerial actions or holding management accountable,
and lack of understanding of auditing limitations were described as conducive to MAM, i.e.
they encouraged senior managers to misstate (Chandler and Edwards, 1994b, p. 39, 42, 46,
51, 57–9, 105, 163, 165–6, 173, 174, 178–9, 182–3, 194, 242, 272–3, 308, 315, and 326).
These were arguments that therefore attempted to blame those who needed protection for
10 The test of reasonableness was introduced to British case law with respect to professions in Lanphier v Phipos
(1838, 8 C & P 475) (Teo and Cobbin, 2005, p. 50).

failures to protect them, and are similar to comments made about recent corporate failures
in an era of creative accounting (see, e.g. Berenson, 2003).
The Accountant also contained excuses to limit the auditor’s responsibilities and these
related primarily to his relationship with senior corporate managers. The first is consis-
tent with a legislative position that persists to the present day concerning management’s
responsibility for accounting systems, i.e. the responsibility for preventing and detecting
fraudulent activity lies with management through its systems of internal control (Chandler
and Edwards, 1994b, p. 18, 93, 144, and 332). Practitioners also reflected on the difficulty
of detecting management fraud because of senior managers’ position of influence (7, 17,
47–8, 157, and 286), the power of the board of directors in matters such as the audit appoint-
ment (39, 42, 51, 53, and 302), the need to assume the honesty of senior managers when
relying on their representations (194, 205, 285, 252–3, 254, and 299), and avoiding an audit
function that could be construed as critical of management (195 and 247–8). These excuses
effectively created the paradoxical dimension to the problem of MAM facilitated by DSM,
i.e. auditors denying or limiting responsibility for detection while assuming the honesty of
senior management when relying on its representations.
4.5. London and General Bank and Kingston Cotton Mill
The principal driver in the construction by lawyers of a model of excuses for corporate
auditors was the Court of Appeal and the major cases that legitimated the position over
MAM by DSM were London & General Bank (No. 2) (1895, 2 Ch 673 CA) (LGB) and
Kingston Cotton Mill Company (No. 2) (1896, 2 Ch 279 CA) (KCM) (Teo and Cobbin,
2005, p. 47–52).
The LGB appeal judgment contains many of the previously mentioned arguments and
that of KCM reinforces them. The importance and influence of the two cases is that, today,
the language in which they were couched underlies most of the public accountancy pro-
fession’s official position of limited responsibility. Moreover, they contain some common
features relevant to this paper – e.g. each had a DSM who took advantage of complex
corporate structures and related financing – aspects that facilitated the MAM. In the case
of LGB, the bank’s chairman was Jabez Balfour, a leading businessman who controlled a
group of companies including LGB.11 The bank was created in 1882 to act as the group’s
banker. Considerable loans were made to the group by the bank and securities were given
in protection. However, the latter were assets of other Balfour companies which, by 1892,
were insolvent—thus making the loans worthless. Balfour appears to have orchestrated
these inter-company transfers and he and his fellow “tame directors” (Valance, 1955, p.
50) were found guilty of misfeasance due to dividends declared on non-existent profits.
On appeal, the LGB auditor was also found guilty of the same offence. The reaction of
the public accountancy profession was to emphasise the constraints to the audit function
mentioned above rather than focus on the issue of coping with a DSM who could override
internal controls and other managers in order to facilitate MAM within a complex corporate
structure. It is worth noting that in later inquiries into company law reform, there were con-
sistent references to corporate businesses being managed in general by honest men (e.g. the
11 Accounts of the LGB case include Valance (1955, p. 42–51) and Haldane (1970, p. 66–73).
Davey Report of the Departmental Committee on Amendments to the Companies Acts, 1862
and 1867 (1895: c.7779, LXXXVIII, 151, para 4) and the Greene Report of the Company
Law Amendment Committee (1926 Cmd. 2657, IX, 477, p. lxviii)). This view appears to
persist and may have been true. However, it created a tradition of reliance by the auditor on
assumed managerial honesty that is obviously misplaced when there is MAM facilitated by
DSM.
The KCM case in 1896 involved overstating the value of the company’s mill and inven-
tory for several years. Dividends were declared on inflated profits. In the case of the mill
overstatement, it is generally accepted that the directors knew the true value. However, in the
case of inventory, the manipulation was made by the general manager and director, William
Jackson, without reference to his fellow directors. He did it “to benefit the company, and
bolster up its credit” (Chandler and Edwards, 1994a, p. 152). On appeal, the auditor was
found not guilty of negligence and the judgment used the same criteria about the parame-
ters of auditing as enunciated in the LGB case and expanded on them in the context of the
auditor as a watchdog rather than a bloodhound (Teo and Cobbin, 2005, p. 49). The case
particularly emphasised the acceptability of relying on the honesty of senior managers and,
as before, ignored the need to find a solution to the problem of auditing in the presence of
DSM who facilitate MAM.
The term “reasonable care and skill in the circumstances” evolved from these cases and
became the foundation for the model of excuses by the corporate auditor with respect to the
detection of MAM. However, it was to be a further half century before public accountants
formally included it in their guidance to auditors.
4.6. Capturing the audit market
British public accountants of the nineteenth century were not solely focused on establish-
ing a model of excuses to deny responsibility for detecting MAM. They were also anxious
to capture a burgeoning corporate audit services market. Maltby (1999) provides a review
of how, prior to 1900, public accountants went about this task. In particular, she (39–45)
reveals that providing business advisory services (e.g. on company promotions and dividend
distributions) was the key to obtaining audits. However, this approach created independence
issues with respect to the audit relationship with senior managers (45–6). It was also an
unfortunate foundation for the corporate audit function because of the relationship of MAM
to DSM, i.e. when the latter were related to the auditor through the provision of business
advisory services but were also facilitating MAM. Arguably, therefore, the seriousness of
the issue of the DSM and MAM appears to have been downplayed for economic reasons
by nineteenth century public accountants intent on capturing the corporate audit market.
4.7. American developments
The early history of American corporate auditing appears to have two stages. The first
period from early to mid nineteenth century witnessed the use of independent and unqualified
public accountants to assist shareholder audit committees to conduct fraud investigations
in companies such as railways (Bookholdt, 1983; Flesher et al., 2005). From these internal
audits came the idea of external audits. US corporate auditing from mid to late nineteenth
century was also closely associated with UK public accountants visiting the US to audit
British investments there (Moyer, 1951). In an unregulated corporate environment, audit
services initially were of a bookkeeping verification style that reflected the British influence
but gradually switched to a test basis with use of external evidence (Moyer, 1951, p. 6–7).
There is no sign of any late nineteenth century debate in the US about the corporate auditor’s
responsibility for detecting MAM.
5. 1900–1961
In 1895, the Davey Departmental Committee on Amendments to the Companies Acts,

1862–1890 recommended the reintroduction of compulsory audits for all UK companies,
and Section 23 of the Companies Act 1900 incorporated this into British legislation. Inter-
estingly, the provision applied only to the balance sheet as there was no mandated profit
statement. The issue of responsibility for detecting MAM was therefore not limited to com-
panies voluntarily contracted to have an external audit through their articles of association.
The act, however, made no provision for professionally qualified auditors, although it is
clear that professional audits were common by 1900—particularly in the largest public
companies (Maltby, 1999, p. 38).
The difficulties of detecting MAM continued to be discussed in the literature and excuses
to support denials or limitations of responsibility were also demanded and supplied by
practitioners. For example, Wardhaugh (1908, p. 5) wrote of shareholders who did not fully
understand the responsibilities of the auditor, and questioned the meaning of terms such
as reasonable care and suspicious circumstances (8–10). The problem of small audit fees
was also discussed (10). Jenkinson (1913, p. 114) criticised shareholders for ignoring audit
reports, and reviewed with approval the limitation of responsibility for detecting MAM in
cases such as KCM (124–6). In contrast in the US, Montgomery (1912, p. 10–11) reported
that fraud detection was a minor audit objective, although businessmen assumed it to be a
major aim.
5.1. US professional regulation
The period 1900–1951 was one in which UK and US institutions of public accoun-
tancy built their memberships, strengthened their members’ standards, and, in particular,
developed a relationship with the state (Miranti, 1990, p. 128–177; Shackleton and Walker,
1998, p. 6–98). In the UK, the relationship predominantly concerned attempts to establish
a monopoly status for public accountants through state registration, and it was 1960 before
a public accountancy body issued an auditing pronouncement (on building society audits).
In contrast in the US, the state in the form of the Federal Reserve Board (FRB) attempted
to regulate auditing from its inception in 1917 by issuing a guidance statement on uniform
accounting prepared by the American Institute of Accountants (AIA) (FRB, 1917). It con-
cerned how to provide uniform audits of specific aspects of financial statements and there
was no mention of the auditor’s responsibility for detecting MAM. Twelve years later, the
AIA revised its 1917 statement for the FRB (1929). The revision again contained instructions
on how to audit different aspects of financial statements. However, its introduction stated
that these audit procedures would not necessarily disclose defalcations, understatements, or
manipulations (Zeff and Moonitz, 1984, p. 39). This was the first institutional limitation by
American public accountants of a primary responsibility for detection of MAM. Contigu-
ously, two corporate failures shook the US public accountancy profession and DSM was
involved in both.
5.2. Kreuger and Insull
The mid-to-late 1920s in the US featured out-of-control money markets, investment

trusts, and myriad corporate combinations. Two of the most notorious companies were
Insull Utility Investments Company (IUIC) and Kreuger & Toll Company (KT). Their
heads were, respectively, Samuel Insull and Ivar Kreuger. Both were well known in the US
and world-wide, and the doors of world leaders, presidents, kings, and high officials always
seemed open to them. However, they were two of the major robber barons of the era.
McDonald (1962) provides a detailed account of Insull’s life and corporate empire. He
managed a maze of private electricity utility monopolies and organised their operation
through a corporate labyrinth of layers of hundreds of holding and subsidiary companies in
various states. Complicating these operations were funding and controls by several trusts
sitting on top of IUIC’s “top heavy pyramid” (Valance, 1955, p. 167–179; Clarke et al., 2003,
p. 164–6). Issues of corporate governance relating to this corporate structure and contestable
asset valuation and other accounting practices emerged in the aftermath of Insull’s death in
1938 in Paris.
Significant as the IUIC fraud was, the Ivar Kreuger saga is more relevant to this paper.
Kreuger was a DSM par excellence. The importance of events at Kreuger relates to the
impact of his demise, the revelations that followed regarding KT’s financial reporting prac-
tices, and the ineffectiveness of its audit. At the time, audits were not a compulsory part of
the financial reporting regulatory regime in the US. Flesher and Flesher’s (1986, p. 421–34)
account of Kreuger’s “giant pyramid scheme” (421) suggests that the timing and scale of
the fraud “contributed significantly to the passage of the Securities Acts” in the early 1930s
(421). Kreuger was a Swedish citizen who moved to the US as his organisation became
one of the largest conglomerates and multinationals imaginable. However, when Kreuger
shot himself in Paris in 1932, subsequent events revealed the façade he had created. He was
a forger and embezzler who deceived millions of investors with false financial statements
over many years. The significance of this is that KT had the “most widely held securities in
America (and also in the world) during the 1920s” (421). As it would be later with, inter alia,
Enron and WorldCom, the market was shocked by what was revealed at KT (Flesher and
Flesher, 1986, p. 421). Stoneman (1962, p. 936) assesses Krueger’s deception of investors12 :
Two things made it possible for Kreuger to falsify his statements without detection.
The first was his absolute dictatorial power over his underlings and the lack of laws in
Sweden making it necessary to employ capable accountants. The second condition to
this practice was the creation of a large chain of holding companies and subsidiaries,
12 See also Shaplen (1990) and Flesher and Flesher (1986).

resulting in such a complication of different enterprises that no accountant, however

canny, could expect to succeed in tracing all of his manipulations.
From its founding as a collection of match companies in Sweden, KT diversified and, by

1931, comprised hundreds of companies. Ultimately, it became best known as an interna-
tional match empire with Kreuger instrumental in securing finance, and American financiers
apparently adored him as a captain of industry in the conspicuous consumption era of
the 1920s. Kreuger’s modus operandi was to assist emerging countries with their national
finances. This was achieved by an ingenious match monopoly proposal with Kreuger provid-
ing countries desperately seeking loan finance with an option unavailable through traditional
banking arrangements. In return for the granting of a match monopoly in a country, Kreuger
would pour millions of dollars raised in other parts of his corporate empire (often in the US)
into government loans. He was therefore an archetypal finance intermediary. But managing
the scale – even the capacity for knowing the scale – was exclusive to Kreuger, and gov-
ernance problems were obvious. Indeed, the investigating accountants, Price Waterhouse
& Company (PWC) were unable to establish the size of a fraud that involved false and
manipulated accounting entries to create or inflate assets and remove or deflate liabilities.
Consider the following statement from PWC in 1932 (May, 1936, p. 110):
The perpetration of frauds on so large a scale and over so long a period would have
been impossible but for (1) the confidence which Kreuger succeeded in inspiring,
(2) the acceptance of his claim that complete secrecy in relation to vitally important
transactions was essential to the success of his projects, (3) the autocratic powers
which were conferred upon him, and (4) the loyalty or unquestioning obedience of
officials, who were selected with great care (some for their ability and honesty, others
for their weaknesses), having regard to the parts Kreuger intended then to take in the
execution of his plans.
From the public’s perspective, the events revealed at IUIC and KT demanded a strong
regulatory response and this appeared with the Securities and Exchange Commission (SEC)
in 1933. Despite this, in terms of accounting and auditing reform, it became evident during
the 1930s that the existing model of self-regulation would continue to be promoted (Chatov,
1975).
The AIA, through its spokesperson and leading practitioner, George Oliver May, began
to discuss accounting and auditing issues with the New York Stock Exchange (NYSE) in
1932, and the correspondence included the possibility of a standard form of audit report.
May was an advocate of the need to stress the “limitations of accounts” and educate the
public of these limitations (Clarke et al., 2003, p. 51). 1932 was also the year in which
the NYSE required an independent audit for all new listed companies. A year later, the
NYSE extended this provision to all listed companies. It also wrote to listed companies
requesting them to ask their auditors if the scope of their audit was as intended in the FRB’s
1929 statement (Zeff and Moonitz, 1984, p. 92–3). Nine leading public accountancy firms
responded, affirming their intention to restrict the auditor’s responsibility to detect defal-
cations, understatements, and manipulations (104–5). More specifically, they emphasised
several excuses used several decades before in the UK, i.e. a lack of understanding by
shareholders of the limited protection of an audit (104), the prohibitive cost of fraud audits
(105), and the need for the auditor to rely on systems of internal control (106). These limi-
tations of responsibility characterised the discussions and, when the AIA (1936) published
an audit guidance statement in 1936 as a further revision of the 1917 and 1929 statements,
scope limitation was repeated with respect to the detection of defalcation, understatement,
and manipulation (137). In addition, company directors were stated to be assuming greater
responsibility for accounting (132), detection of irregularities was deemed to require a spe-
cial investigation (134), and reliance on internal controls and management representations,
as well as the use of audit tests by the auditor, became the foundations of the modern
audit (135–7). The model of excuses was therefore formally stated by American public
accountants in 1936 and the paradox for the auditor of MAM facilitated by DSM became
institutionalised.
5.3. McKesson & Robbins
The US position on corporate auditor responsibilities was disrupted by the SEC case of
McKesson & Robbins (MR) in 1939. MR was a wholesale drug company and, by 1937,
one of the largest of its type (Baxter, 1999; Keats, 1964). Its CEO, Donald Coster, founded
the business in 1923 and, by 1937, MR had sales of US$ 170m, profits in excess of US$
3m, and assets totalling nearly US$ 90m. However, one-half of MR’s reported profits came
from a fictional Canadian subsidiary. MR operations were a model of their time and its
accounting systems appeared in a number of leading accounting textbooks. Its auditor was
PWC, which failed to discover the MR operations in Canada were bogus and that Coster
(and his three brothers) used fictitious accounting records and documents to disguise the
fraud. Coster was a convicted fraudster and the MR fraud was discovered during a liquidity
crisis. The company was put into receivership, fictitious assets, liabilities, and profits were
exposed, and the NYSE suspended MR’s shares. The SEC investigated the fraud, Coster
committed suicide, and his brothers were tried and jailed.
PWC’s audit of MR focused on its balance sheet and was, seemingly, unconcerned about
the large divisional contribution to profits from Canada. Debtors were unconfirmed and
inventories not physically inspected. Audit staff was seasonal and inexperienced, and the
engagement partner unconcerned about the presence of DSM. The SEC report was highly
critical of PWC, e.g. it alleged tha: the auditor made no risk assessment of the client;
senior staff participated minimally in the audit; junior audit staff was typically temporary,
inexperienced, and unfamiliar with the business; internal control assessment was poor; and
audit staff generally exhibited a lack of scepticism when relying on representations from
DSM. Much of this was generally accepted at the time. However, within months, the AIA
issued new standards on inventory and debtor verification, as well as audit appointments
and reports (Zeff and Moonitz, 1984, p. 173–180).
Despite these changes, AIA standards contained familiar limitations on auditor respon-
sibility, i.e. the auditor is neither an insurer nor guarantor; all that is needed is reasonable
care and skill in the circumstances; management is responsible for accounting and safe-
guarding assets; the discovery of defalcations is not a primary objective of auditing; and
there is a need to rely on systems of internal control and the integrity of management in the
absence of suspicions to the contrary (174–5). Twenty-four Statements on Audit Procedure
were issued by the AIA between 1939 and 1949. In announcing the series, the AIA Council
stated that the audit was not designed to discover all defalcations and that detection required
the maintenance of adequate systems of internal control (198–9). Reliance on managerial
integrity, the problem of collusion, and suspicious circumstances were all emphasised as
mitigating factors (199).
5.4. Formalising reasonable care
In 1947, the AIA issued Tentative Statement of Auditing Standards: Their Gener-
ally Accepted Significance and Scope as further clarification of auditor responsibilities
in the US (AIA, 1947). In particular, it offered guidance in general, field work, and
reporting standards (Zeff and Moonitz, 1984, p. 389). The general standards empha-
sised competence, independence, and due care (390–8). The latter term was a renaming
by American public accountants of the English legal concept of reasonable care and
skill in the circumstances (396). The discovery of errors and irregularities was men-
tioned indirectly when dealing with reliance on internal control systems (404).13 MAM
was mentioned, but only in the context of professional misconduct and failure to report
when misstatement was known (416). These US guidance statements suggest that, by
1947, the limitation of responsibility to detect MAM remained as stated in previous
decades. Indeed, 4 years later, the American Institute of Certified Public Accountants
(AICPA, 1951, paras 12 and 13) in its Codification of Statements on Auditing Proce-
dure reiterated the 1939 denial of a primary responsibility for detecting defalcations
and other irregularities, and focused instead on the auditor’s need to rely on internal
controls and surety bonds, the prohibitive cost of detecting defalcations and other irreg-
ularities, and acceptance of a limited responsibility for detection only when suspicions
were aroused.
In 1960, however, the AICPA (1960, para 5) in Statement of Auditing Procedure 30
appeared to modify its 1951 position by arguing responsibility if there was non-compliance
with generally accepted auditing standards (GAAS). Nevertheless, it restated the mantra
that the auditor was neither an insurer nor guarantor and was expected to act with due
professional care and skill in accordance with GAAS (para 8).14 At approximately the
same time in 1961, The Institute of Chartered Accountants in England and Wales (ICAEW)
(Anonymous, 1961) adopted a similar position in its first general statement on auditing,
General Principles of Auditing. The statement’s basis was expressed in terms of the 1896
dictum of the KCM case, i.e. reasonable care, skill, and caution in particular circumstances
(Anonymous, 1961, p. 1). The statement (8) also adopted a position and used identical
terminology to that in the AICPA (1960, para 7) statement, i.e. the detection of suspected
defalcations and other irregularities was a function or service separate from the audit. Thus,
by the 1960s, denial of primary responsibility by the major professional bodies continued,
and detection of MAM was regarded as an additional service to the client. Moreover, UK
13 “Errors and irregularities” was used at this time in the US in preference to fraud or MAM (as defined in this
paper). In 1951, the term changed to “defalcations and other irregularities” and, in 1961, the latter was used in a
UK guidance statement for the first time.
14 The statement (AICPA, 1960, para 5) defined fraud for the first time in the institutional literature, i.e. as
defalcations and other irregularities, and deliberate managerial misrepresentation.

and US approaches to the issue were compatible and reliant for their philosophical basis on
the late nineteenth century judicial pronouncements of British court cases.
6. 1961 to present day
The 1960s saw little change to the established institutional position in the UK and US.
However, MAM facilitated by DSM continued, and not always in these countries. A growing
Australian commercial environment mirrored British and American characteristics. For
example, in 1963, the case of Reid Murray Holdings (RMH) attracted considerable interest
(Clarke et al., 2003, p. 55–65; cited page references below are also to this source).
6.1. Reid Murray Holdings
Formed in 1957, RMH was one of largest retailers in Australia in the early 1960s. It
entered receivership in 1963 with a US$ 450m deficit (in 2002 terms) (55). The group’s
CEO, Oswald O’Grady, was acknowledged as a charismatic but dominant manager with a
favourable reputation in the wider community. RMH had a complex organisational structure
resulting from numerous takeovers funded by share issues and borrowing. Much of the
latter ended up by inter-company transfer in one of O’Grady’s family companies. The
MAM included overstatement and misclassification of assets over several years. The fraud
was discovered in November 1960 when a government-imposed credit squeeze required
a reduction in borrowings and credit liabilities. Despite MAM, however, a government
investigation found O’Grady not guilty of fraud.
O’Grady earned the dubious accolade from the inspectors of being as inept a manager
that could be met. He was depicted as an artless victim of his own incompetence—albeit
a visionary and charming man, and in his native South Australia a local hero until RMH
crashed. As a DSM, O’Grady was able to sweep others along in his enthusiasm for property
development. His brief performance in the Australian corporate scene illustrates circum-
stances, perhaps as events in the 1990s and beyond confirm, the perfect pre-conditions in
which DSM thrive. First, there was the public contagion of prospects for rapid growth, aptly
described in the Interim Report in the RMH failure (64):
It was the spirit of the late ‘50s which encouraged the public (enchanted by the
spectacular growth and apparent profitability of the Reid Murray Group as shown
in the published accounts) to pour into Reid Murray Acceptance much of the money
which was subsequently lost. . . Easy availability of huge sums of public moneys. . .
and the acceptance of the view (both inside and outside the group) that such sums. . .
could be indiscriminately used to construct and expand the group were necessary
pre-conditions for the losses which followed.
Second, there was unbridled confidence exhibited by the individual manager, arguably
backed up by a genuine belief that anything, indeed everything was possible, no matter how
clear the signs that it was not. That members of the general investing public were so easily
sucked into such a situation is indicative of how hard they work in those settings to convince
themselves that what is obviously financially false is in fact true.
6.2. Thomas Gerrard & Sons
The 1960s was a period in which public perceptions continued to assume that the cor-
porate auditor was responsible for detecting “major fraud and error” (Lee, 1970, p. 294).
In an extensive survey, Lee found more than eight of every 10 auditors, corporate man-
agers, and audit beneficiaries believed this was a principal audit objective.15 In 1968, the
case of Thomas Gerrard & Sons Ltd (Ch 455) provided a decision consistent with this
perception (Godsell, 1991, p. 68–70). The case involved a DSM and confirmed the 1896
position in the KMC case, although the overall standard of reasonable care was more
exacting than in 1896. The judgment confirmed the auditor should exercise healthy cyn-
icism about senior managers in suspicious circumstances. The CEO had been a trusted
official and was well respected in the wider community. However, he falsified inventory
for many years by manipulating year-end cut-off procedures undetected by the auditor. The
judge rejected the auditor’s excuses of lack of time and entitlement to rely on managerial
representations.
6.3. Equity funding
A US case in 1973 intensified public scrutiny of the auditor’s role with respect to MAM
(Seidler et al., 1997).16 The Equity Funding Corporation of America (EFCA) was founded
in 1959 and specialised in innovative financial products that combined life insurance policies
with mutual fund investment. The company’s profits were generated from commissions on
the sale of mutual fund shares and life insurance policies sold to re-insurance companies.
Stanley Goldblum became EFCA’s chairman in 1969 and the company grew to be one of
the largest life insurance companies in the US. Goldblum appointed Fred Levin as vice
president of life insurance operations. Both men were central to the fraud. The company
was a stock market favourite and, in 1972, had total assets in excess of US$ 500m and
annual profits of US$ 26m. A year later, it collapsed when a whistleblower revealed a fraud
of more than US$ 60m of inflated mutual fund assets and US$ 80m of other fictitious or
inflated assets. Two-thirds of more than US$ 3b of life insurance policies was bogus due to
Goldblum and Levin generating computerised documents, circumventing internal controls,
pressuring employees, and deceiving the auditors. Goldblum and Levin were imprisoned,
the audit engagement partner and two managers convicted of fraud, and two audit firms
paid US$ 44m in an out-of-court settlement. The AICPA created a special committee to
examine whether current audit standards were sufficient to cope with a situation such as
EFCA (AICPA, 1975). It reported, with some reservations, that standards were adequate
(AICPA, 1975, p. 27). The committee also addressed the possibility that the audit opinion
could be perceived as providing a higher degree of assurance about the absence of fraud
than was possible (35–40). It reiterated the position outlined by the AICPA (1960).
Also as a result of EFCA (and other large corporate collapses of the time including
Penn Central, Stirling Homex, and National Student Marketing), the AICPA in November
15 Later surveys provided results consistent with Lee (e.g. Humphrey et al., 1993, p. 41–2; see also Humphrey et
al., 1992, p. 53–5).

16 There were other US auditing scandals in the 1950s and 1960s (see Woolf, 1982).
1974 established the Cohen Commission on Auditors’ Responsibilities to examine the

role of the auditor and the adequacy of GAAS. The Commission reported that corporate
financial statement users were entitled to assume these were reliable because the auditor
gave reasonable assurance they were free of MAM (AICPA, 1978, p. 16). In response, the
AICPA’s upgraded Statement on Auditing Standards 30 (AICPA, 1977) repeated the general
approach of limited acceptance of responsibility as enunciated in its 1960 statement, i.e.
the auditor was not an insurer or guarantor, and that he should exercise due care in the
application of GAAS. In other words, despite cases such as EFCA, and detailed enquiries
such as the Cohen Commission, arguably nothing had changed in the 1970s in the US, and
the issue of the DSM and MAM was not addressed.
6.4. British position
The UK position was equally static. Humphrey et al. (1993, p. 40) report on institutional
activities in the 1980s concerning the detection of MAM. These efforts culminated in an
audit guideline from the Auditing Practices Committee that maintained the limited role of
the auditor (APC, 1990). Meantime, however, leading public accountancy firms offered
fraud investigation as a separate service (Humphrey et al., 1993, p. 40). The background to
the 1990 statement was relatively clear. Research revealed perceptions of the auditor being
responsible for the detection of fraud generally, and the guidance statement of the APC
(1990) suggested auditors should plan to have a reasonable expectation of detecting MAM
(41–2; see also Humphrey et al., 1992, p. 53–5). Then, following financial scandals in the
1980s (e.g. Johnson Matthey Bank) and pressure from the UK government for auditors
to assume greater responsibility (e.g. the 1984 Gower report on investor protection),
the British professional bodies initiated two investigations (45–9). With respect to fraud
reporting, the recommendation was auditors should communicate directly with relevant
supervisory bodies rather than shareholders because of client confidentiality (48). So far as
fraud detecting was concerned, the two investigations supported the status quo of limited
responsibility (49–50) and this was reflected in the final guidance statement (APC, 1990,
para 14). Normal audit procedures were stated to be problematic if misstatement was
intentional and involved collusion and concealment.
Humphrey et al. (1993, p. 55–7) conclude that, in the 1980s, there was little change
in the British profession’s lack of acceptance of responsibility for detecting MAM. It
assumed a right rather than a duty to report to an appropriate authority in the public
interest, and to regard fraud detection generally as a management service. In other words,
British auditors appeared to claim an ability to detect MAM if the fee was appropriate
to the work required, the litigious environment acceptable, and the audit appointment
process less inhibiting (56). Humphries et al. particularly questioned in these circum-
stances what the current audit was capable of detecting in relation to MAM by senior
management (56).
6.5. Further American developments
In 1987, following numerous financial scandals, the Treadway Commission (TC), a pri-
vate sector initiative involving the AICPA, reported on its examination of corporate financial
management and fraudulent financial reporting (NCFFR, 1987).17 The TC concluded gen-
erally that fraudulent reporting was a serious issue and that auditors were failing to detect
it. The TC recommendations resulted in nine expectations gap auditing standards (Guy
and Sullivan, 1998), including a further statement on the auditor’s responsibility for MAM
detection, Statement on Auditing Standards 53 (AICPA, 1988). In this statement, the AICPA
(paras 7 and 8) declared as before that the corporate auditor was responsible for ensuring
his opinion took into account the possibility of the existence of MAM, i.e. the auditor was
expected to provide reasonable assurance that the financial statements were free from MAM.
In addition, in the context of the characteristics of accounting errors and irregularities, the
auditor was expected to use risk assessment as a basis for audit planning, and exercise due
care and a proper degree of professional scepticism. These were not substantive changes to
the previous position, but they provided a more explicit recognition of what the auditor was
expected to do to meet the challenge of his limited responsibility. Despite this, the public
accountancy profession continued to deal with embarrassing cases of MAM facilitated by
DSM.
6.6. Maxwell Communications
Robert Maxwell was an immigrant to the UK who entered publishing in 1946. He bought
Pergamon Press (PP) in 1951 and became a Member of Parliament in 1964. In 1969, he
attempted to sell PP to an American Corporation using false information. A report from
Department of Trade & Industry (DTI) inspectors in 1973 stated that Maxwell was not to
be relied on to exercise proper stewardship of a public company. A year later, however, he
regained control of PP and, in 1981, obtained control of the British Printing Corporation
(BPC) (renamed Maxwell Communications Corporation [MCC]) in 1986. Two years earlier,
a private company owned by Maxwell purchased Mirror Group Newspapers (MGN). He
unsuccessfully attempted to dominate the tabloid press with this investment and went public
with MGN in 1991. Other media and publishing acquisitions and sales took place prior to
1991 when a catastrophic financial collapse of MCC occurred. Maxwell drowned in the
same year and his companies filed for bankruptcy in 1992. Three years later, a DTI report
was published (Thomas and Turner, 2001).
The DTI report stated that the primary responsibility for the fraud lay with Robert
Maxwell. The fraud involved the misappropriation of funds and MAM, and was achieved
through a complex private ownership of more than 400 Maxwell companies (Clarke et al.,
2003, p. 276). PP and the BPC were ultimately controlled directly by Maxwell through
the Maxwell Foundation founded in 1970 and based in Liechtenstein. MGN was part of
the Foundation and Maxwell used the cash flow of MGN to fund his other businesses. In
particular, from 1985 to 1991, he raided the MGN pension funds to provide cash to repay
debt elsewhere in his group. The scandal was compounded by the fact that the pension funds
were invested in Maxwell companies and shares in MCC were used as security for growing
business debts. In effect, all parts of MCC, including its pension funds, were treated by
Maxwell as one entity. He purchased shares in MCC to support their market price and,
17 For a brief review of these financial scandals, see Previts and Merino (1998, p. 367–70).
by 1990, owned more than three-quarters of the company. The public flotation of MNG
in 1991, however, precipitated the final collapse as it removed the cash flow source from
Maxwell’s direct control. Eventually, there was no cash available to meet due debts. By
1991, missing pension fund assets totalled £458m. The senior audit partner on the MCC
engagement was censured and fined for admission of fifty-nine errors of judgment.
6.7. Bank of Credit and Commerce International
In 1991, Bank of Credit and Commerce International (BCCI) closed with the discovery
by its auditors, PWC, of a fraud involving billions of dollars of lost or fictitious assets.
Because of a multiplicity of ongoing legal actions and several national governments not
releasing documents, it is hard to determine the exact size of the fraud. It is estimated that
there were US$ 13b of missing BCCI assets and original claims of creditors totalled US$
16b. By 2003, three-quarters of these claims were settled for nearly US$ 6b and the total
costs of liquidation then exceeded US$ 1b. In 1998, PWC paid £117m in an out-of-court
settlement and without admitting liability. The most comprehensive account of the fraud
is the US Senate’s report on BCCI in 1992 and what follows is a brief summary from that
source (Kerry and Brown, 1992; see also Beaty and Gwynne, 1993).
Agha Hasan Abedi, an Indian banker, founded BCCI in 1972. He had worked in Indian
and Pakistani banks. BCCI was based in Luxembourg, had close financial links with the
Sheikh of Abu Dhabi, and was banker for the United Arab Emirates. BCCI activities from
1973 until 1991 became global and its operations included Europe, Africa, Asia, and the
Americas. BCCI entered the US banking system by acquiring banks there and became
banker for governmental funds of many nations. According to Kerry and Brown, its main
activities were money laundering, drug and arms dealing and trafficking, fraud, extortion,
and bribery. The accounting fraud involved fictitious loans and other transactions, bad
lending and investment, stolen deposits and investments, and unrecorded deposits. PWC
became the overall BCCI auditors in 1997, having previously shared the audit with Ernst &
Young (EY). The pre-1987 arrangement of multiple auditors was a key factor in the ability
of BCCI senior managers to hide their fraud. The US Senate report accused PWC of failing
to protect BCCI depositors and creditors when it had been aware of its accounting practices.
The full story of BCCI may never be fully told. What is of most concern to this study is the
existence of DSM in a multi-national corporate structure of such complexity and depth that
no individual jurisdiction (including banking authorities) was fully aware of what BCCI
was doing.
6.8. Institutional responses
In the context of cases such as MCC and BCCI in the UK, the research committee of the
Institute of Chartered Accountants of Scotland (ICAS) concluded that auditors had removed
the detection of MAM from the list of primary audit aims rather than lost it because of lack
of demand (McInnes, 1993, p. 12). ICAS reiterated public perceptions of detection as a
major audit aim (13), as well as the profession’s long-lived excuse of the high cost of fraud
audits (15). The report recommended the auditor plan to take into account the specific risk of
senior managers committing fraud (16). However, this was not adopted by other professional
bodies. For example, in 1995, the Auditing Practices Board (APB, 1995, para 18) issued
Statement of Auditing Standards 110 in which the auditor was required to plan to have a
reasonable expectation of detecting fraud. Excuses abounded. Auditors were stated to have
particular problems detecting MAM by DSM because of the ability of the latter to operate
in a complex structure, override controls, collude, and interfere with accounting practices
and audit evidence (APB, 1995, para 22). Further, 3 years later, in a consultation paper the
APB (1998) acknowledged the close relation between MAM and DSM but continued to
provide excuses for not extending responsibility (including the ability of senior managers
to override internal controls and time constraints on reporting).
6.9. America and elsewhere in the new millennium
In late 2001, Enron Corporation (EC), one of the largest US companies, announced a
third-quarter loss of more than US$ 600m and a US$ 1b write-down of impaired assets
connected to off-balance sheet partnerships called special purpose entities (SPEs) con-
trolled by its CFO, Andrew Fastow (Brody et al., 2003; Sridharan et al., 2002). An SEC
investigation commenced into conflicts of interest resulting from the SPEs. EC disclosed a
downwards restatement of its published earnings from 1997 to 2001 inclusive of US$ 587m
and entered bankruptcy protection. A criminal investigation took place and EC’s auditors,
Arthur Andersen (AA), and its engagement partner were found guilty of obstruction of
justice. AA admitted shredding audit working papers relating to EC and liquidated in 2003
following a rapid loss of existing clients.
EC was a global energy trading company, formed in 1985 by merger of two energy
suppliers. AA was not the auditor of the SPEs associated with EC. The company began to
trade in energy units in 1994 following deregulation of the industry. Its chairman and CEO
from 1986 was Kenneth Lay and its COO was Jeffrey Skilling from 2001. In 2001, AA
discussed dropping EC as an audit client when a senior executive became Secretary of the
Army. EC’s energy contracts included many with the Army. Shortly after the EC collapse
in 2001, Skilling resigned and Lay replaced him as COO. An EC vice president, Sharon
Watkins, internally recorded her concerns about accounting irregularities relating to loans
from banks flowing through the SPEs to EC, Lay resigned in 2002, and the NYSE removed
EC’s stock from the board. Watkins testified to the House Energy & Commerce Committee,
suggesting that Lay had not understood EC’s trading and accounting practices and that
Skilling and Fastow managed in an intimidating style. Also in 2002, a class action lawsuit
started on behalf of EC shareholders between 1998 and 2001 because of false reporting
and insider trading. Lay and other defendants appear to have sold EC stock worth more
than US$ 1b. To date, there have been several court decisions and settlements, including
AA settling for damages of US$ 40m. For example, EC’s treasurer has been found guilty
of fraud and fined for manipulating the company’s earnings. Its chief accounting officer
entered a plea bargain on securities fraud. Andrew Fastow was found guilty of fraud and
entered a plea bargain. Skilling and Lay were charged with fraud and found guilty. Before
sentencing initially scheduled for 9/11, Lay died of a heart attack. Skilling was sentenced
to 24 years and 4 months gaol.
Although details of the MAM by EC and its related SPEs await further examination and
disclosure, it is clear that DSM were associated with the fraud. It is also alleged that major
financial transactions to improve the reported financial state and performance of Enron were
facilitated by questionable participation by major financial intermediaries. In addition, the
auditor appears to have been aware of key decisions relating to organisational structures that
permitted the fraud, and ultimately destroyed audit working papers; whether in the ordi-
nary course of business is contested still. AA acted not only as external auditor for some
companies within the EC group but also as internal auditor from 1993. Existing evidence
of the EC case suggests a policy of aggressive accounting in which transactions and con-
tracts were recorded off-balance sheet by using SPEs that legally did not require accounting
consolidation. Sales were recorded when long-term contracts were signed. Federal regu-
lators were persuaded to allow EC to use what some commentators incorrectly described
as mark-to-market accounting from 1992 onwards. A better appellation is mark-to-model
or guesswork accounting (Clarke et al., 2003, p. 259–62). Projected contract profits were
treated as current income and senior managers’ compensation related to contract profits.
Debts were off-loaded to SPEs and financial derivatives used to hide losses on stock and debt
on company acquisitions. Generous estimates of market values were attributed to long-term
energy contracts and financial assets. Much of the accounting was subjective, not supported
by strong evidence, and difficult to challenge by the auditor. In particular, most of the fraud
took place in SPEs not audited by AA.
6.10. WorldCom
EC shocked the global financial community with the scale of the MAM in the presence
of DSM and auditors. However, as the facts of the EC scandal emerged another became
headline news.18 WorldCom (WC) was one of the largest US corporations in 2002 when
it collapsed with an apparent US$ 11b of MAM. WC communication systems handled
one-half of the world’s e-mail traffic and it was the second largest US long-distance phone
carrier. The company entered bankruptcy protection in 2002 with US$ 41b of debt and was
later renamed MCI. By 2003, MCI had returned to profitability. At that time it was the
world’s largest bankruptcy. The details of the fraud are difficult to outline, as investigations
are ongoing. However, two reports have been lodged with the Bankruptcy Court. These
relate to investigations by a former Chief of Enforcement at the SEC (on behalf of WC)
and a former US Attorney General (on behalf of the Bankruptcy Court). Their findings are
that the fraud was associated with DSM, and there were two sets of accounting records, lax
internal controls, and poor oversight by the board of directors. The alleged MAM included
inflated revenues, treating maintenance costs as capital expenditure, and failure to write off
bad debts. The company’s auditor was AA, which ceased practicing in 2003.
Again several DSM were present. CEO Bernie Ebbers was found guilty of fraud and
imprisoned for 25 years. CFO Scott Sullivan pled guilty to securities fraud, conspiracy, and
reporting false information to the SEC and sentenced to 5 years gaol. He and Ebbers had
unfettered control in the company. WC’s comptroller and directors of general accounting,
management reporting, and legal entity accounting also pled guilty to fraud charges. The
company initially admitted hiding more than US$ 1b of losses by accounting for operating
18 Sources include Forbes, Reuters, Jettner (2003), Malik (2003), and Zekany et al. (2004).
costs as capital expenditure, and consequently restated its financial results for 2001 and the
first quarter of 2002. Later disclosures revealed accounting abuses in excess of US$ 7b,
and led to restated 2000 financial results. Most recent disclosures add a further US$ 4b of
MAM. WC has settled its fraud case with the SEC and been fined.19
6.11. Australia
Clarke et al. (2003, passim) observe that largely unexpected failures in the 1960s to
the 1990s revealed problems for auditors (and accounting generally). Some of the cases
reported therein were where fraud was alleged or proven, and in nearly all cases there had
been a DSM. As demonstrated below, Australia faces a renewed accounting and auditing
crisis in the first years of the new millennium in the aftermath of cases that have similarities
with major collapses a decade earlier.
6.12. Bond/Bell Resources20
Bond Corporation (BC), one of Australia’s leading companies in the 1980s, suffered
financial problems circa the 1987 stock market crash and was placed in provisional
liquidation in the early 1990s. Founder Alan Bond was found guilty of “Australia’s largest
corporate fraud” – the Bond Corporation (BC)/Bell Resources (BR) “cash cow transaction”
– in which intermediaries were used to facilitate upstream transfers of approximately
US$ 1.2b of cash funds from subsidiary BR to other BC subsidiaries and related parties.
Importantly, both BC and BR were listed holding companies and under the control of
Alan Bond—BC through direct holdings, and 53% of BR by virtue of holdings of related
parties. Johnson (2000, p. 66), though illustrating only part of the fraud (Clarke et al.,
2003, p. 179), reveals the complexity of the cash cow transaction. “Intermediaries” to the
transactions were “smallish” BC-related companies. “Borrowers” were Bond Corporation
Finance, Bond Corporation Holdings (BCH), and Alan Bond’s family company, Dallhold
Investments. The Statement of Facts in The Queen v. Alan Bond (1997: 18) exposes the
motivation for the transactions: “Early in 1988 BCH was having cash flow difficulties
and found it difficult to borrow from external financial institutions” (Johnson, 2000, p.
67). External financial institutions lent money to individual companies in the BC or BR
groups using negative pledges, avoidance of which entailed related parties moving funds
between group companies as if they comprised one enterprise. Because of the dominance
of Alan Bond and other top-level BC executives, information about BC was released to
shareholders and lower-level operational managers on a need-to-know basis. Mr. Justice Sir
Nicholas Browne noted Alan Bond’s 1980s failed attempt to take over Lonrho: “It is a very
remarkable phenomenon when you think that you have a company that had by that stage
invested 360 million pounds—odd that not a single piece of paper is available supporting
that fact” (Haigh, 1989, p. 41). The audit implications of this can only be speculated. In
1995, criminal fraud charges were laid against Bond and two other BC directors over the
“cash cow transaction” and all were eventually found guilty and imprisoned.
19 Zekany et al. (2004, p. 102–4) reveal the importance of DSM in WC.

20 Details from Clarke et al. (2003, p. 178–80).
Arguably, fund movements in the manner described above are contrary to a fundamental
principle of English law, which is the separate legal entity. Bond admitted actions con-
sistent with the erroneous but prevailing view that the group is, for all managerial intents
and purposes, a dominance-friendly single entity. But, whereas that view is embedded in
conventional accounting thought, it is inconsistent, generally, with the legal framework in
which companies operate. This piece of accounting sophistry lies at the root of much com-
mercial mischief, especially involving DSM such as Bond when they engage in dubious
financial transactions. A major difficulty for the auditor in such cases is to determine the
entity under consideration.
6.13. HIH
HIH was reportedly the second largest insurance company in Australia and “one of the
largest corporate collapses” in Australia, with an estimated deficiency of US$ 5.3b.21 The
proposed statements of claim lodged by the HIH administrator threatened a US$ 5.3b lawsuit
against many, including Australia’s federal government and the national insurance industry
watchdog APRA, its prudential regulator, suggesting they were negligent in allowing HIH
to collapse in 2001. Indeed, the report of the HIHRC (vol. I, p. xiii) concluded that “despite
[myriad governance] mechanisms the corporate officers, auditors and regulators of HIH
failed to see, remedy or report . . . [the] obvious.” This was a situation not assisted by the
dominance of HIH CEO and founder Ray Williams.
With more than 240 companies, HIH operated in 16 countries over 5 continents. The
group comprised several Australian insurance companies maintaining ubiquitous insurance
cover for a variety of purposes. Incurring significant amounts of obligations that had been
purportedly reinsured (rather than provided for) proved a major factor in the collapse of
HIH. Reinsurance was shown to consist of sham transactions that were actually loans.
Overseas expansions in the UK and the US evidenced group enterprise action that was
claimed by many appearing before the HIHRC to have been a significant factor in the HIH
collapse.
In the HIHRC it was claimed that at all times Ray Williams played a dominant CEO
role at HIH, with its board proving to be an ineffective monitor of William’s activities.
The HIHRC (2003, vol. III, p. 273–77) report details how two major and ultimately fatal
transactions were allegedly actioned by Williams—the FAI acquisition by HIH and Allianz’s
fatal purchase of a major part of HIH’s cash flow base just before its ultimate collapse. The
FAI acquisition was HIH’s Achilles heel and as bad a commercial decision as was possible.
Williams, with the absolute trust and confidence of his board, or too much strength for them
to contain, was able to ensnare HIH in the FAI takeover without presenting any appropriate
due diligence report. According to the HIHRC (2003, vol. III, p. 273) report:
Decisions. . . were often made by the Board on short notice with insufficient informa-
tion and without adequate analysis. . .. [The board accepted] views of management
uncritically... the opening of the UK branch, the reacquisition of Care America, the
FAI acquisition and the Allianz transaction.
21 Details from HIH Royal Commission Report (HIHRC, 2003) and Clarke et al. (2003: especially p. 222–45).
Williams might be considered the epitome of the DSM genre. However, whereas AA
was subjected to some criticism in respect of its audit of HIH (primarily for what it did not
detect), no charges were laid against the firm.
The HIHRC (2003) report implies that for the most part the HIH board, and contestably
perhaps the auditor, accepted virtually everything Williams put to them. His dominance
overrode his sensitivity to the commercial reality of HIH’s circumstances. In the years since
the collapse, the industry regulator, APRA, adjudged several of HIH’s directors and other
corporate officers, unfit to work in the insurance industry.
6.14. Institutional responses of public accountants
EC and WC precipitated responses by the AICPA to the problem of the audit detection
of MAM. First, the Private Securities Litigation Reform Act 1995 enshrined the dictum
of auditors providing reasonable assurance they would detect illegal acts having a mate-
rial effect on financial statements. It therefore legitimated a credible legal excuse to limit
responsibility. The key feature is the term “reasonable assurance.” It has not been defined
and is circumstantial in nature (Cullinan and Sutton, 2002, p. 300–1). Nevertheless, the
AICPA continued to use it in Statement of Auditing Standards 82 (AICPA, 1997, para 2),
in which the auditor was required to be responsible for providing reasonable assurance that
financial statements were free of MAM. Misstatement was defined as errors and fraud.22
Statement 82 (para 10) also limited responsibility by arguing other excuses used in the
past, i.e. managerial concealment and collusion, and the difficulty of judging risk factors.
Statement 82 had two specific requirements for the auditor—assessing and judging the risk
of MAM when designing the audit (paras 11 and 26), and documenting these assessments
and judgments (para 37).
Thus, Statement 82 did not change the previous limited responsibility policy of Amer-
ican auditors but it did make more explicit the need for the auditor to think explicitly
about the risk of MAM in relation to audit procedure. Statement 82 also provided an
appendix containing examples of risk factors relating to MAM. These were categorised
as incentives and pressures on management (e.g. economic threats, market expectations,
and compensation packages), opportunities (e.g. the nature of the business, monitoring of
management, complex organisational structures, and internal control systems), and attitudes
and rationalisations of management.23
The need for auditors to emphasise even a limited responsibility for detecting MAM
was made clear in a report completed for the AICPA in 2001 (Beasley et al., 2001). The
authors examined the audit in 45 SEC enforcement actions between 1987 and 1997 that
involved fraudulent reporting and found the most frequent audit problems were associated
with gathering sufficient audit evidence (80% of actions), exercising due professional care
(71%), and demonstrating appropriate professional scepticism (60%) (Beasley et al., 2001,
p. 65). These consistent failures were the central focus of judicial decisions and public
accountancy guidance and mandate since the late nineteenth century. An earlier report by the
22 This was the first US statement to use the term fraud and replace the previous term of irregularity.
23 Albrecht and Romney (1986) provide an early study of audit risk factors or “red flags” of managerial misstate-
ment involving DSM. See also Argenti (1976) and Heiman-Hoffman et al. (1996).
same authors and prepared for the Treadway Commission revealed characteristics of frauds
during the same period (Beasley et al., 1999). Two hundred and four companies investigated
by the SEC Enforcement Division between 1987 and 1997 had average total assets of US$
533m and average frauds of US$ 25m (Beasley et al., 1999, p. 1). The CEO and/or the
CFO were involved in 83% of these frauds. More than one-quarter of companies changed
auditor and 70% had audit committees, mostly independent but meeting infrequently.24 It
is difficult not to envisage the presence of DSM in these situations of MAM where the
auditor had insufficient evidence and was not exercising due care and proper professional
scepticism.
Statement on Auditing Standards 99 (AICPA, 2002) is the most recent American state-
ment on responsibility for the audit detection of MAM. Its objective is to clarify the auditor’s
responsibility and its emphasis is on the auditor thinking about the risk of misstatement
before and throughout the audit, including brainstorming, expanding the range of informa-
tion sources, identifying circumstances in which management could override controls, the
presumption that improper revenue recognition is a fraud risk, and checking journal entries
(Ramos, 2003). It does not alter the previous acceptance of limited responsibility based on
reasonable assurance and continues the tradition of supplying excuses to emphasise this
limitation. The following excuses illustrate this, e.g. managerial intent is difficult to judge
(AICPA, 2002, para 5); management can manipulate accounting and override internal con-
trols (para 8), conceal fraud (para 9), and collude to conceal (para 10); and the nature of
audit evidence and misstatement make absolute assurance impossible (para 12).
6.15. Practitioner responses
It is difficult to determine individual audit practitioner responses to situations such as EC

and WC and requirements such as Statements 82 and 99. One possible source is the audit
research literature and there have been a small number of recent studies associated with
the auditor’s responsibility for detecting MAM. The first is a critical review by Cullinan
and Sutton (2002). They examined the recent actions of audit firms and public accountancy
institutions in the US and argue that, at a time when the public accountancy profession in
Statement 82 appears to accept some responsibility (i.e. in providing reasonable assurance
of detecting MAM), the larger audit firms are focusing less on checking specific accounting
records and transactions (where manipulations of senior managers take place) and more on
analysing and assessing internal control processes and systems (which relate typically to
lower-level employee fraud) (Cullinan and Sutton, 2002, p. 298). The paper further argues
(298) that MAM relates predominantly to senior managers, and uses the 1999 Treadway
report (see above) to demonstrate the involvement of senior managers in report fraud.
Cullinan and Sutton (2002, p. 301) state that the focus of current audit standards is on
senior management being responsible for detecting and preventing fraud rather than the
issue of senior managers perpetrating fraud. The inherent limitations of internal control
systems (302) and analytical review (305) are stated to be ignored in these standards.
DeZoort and Lee (1998) studied the effect of Statement 82 compared to Statement 53 on
perceptions of responsibility for detecting MAM. Using vignettes of material and immaterial
24 See also Barber (2005).

reporting and non-reporting fraud based on real cases, and using external auditors, internal
auditors, and fraud examiners as subjects, the study found that the perceived responsibility of
the external auditor for detection of MAM was higher under Statement 82 than Statement 53.
Mock and Turner (2005) reviewed audit documentation for 202 audits for each of 2 years
by 3 audit firms concerned with responding to Statement 82 between 1997 and 1999. They
investigated audit risk factors relating to management characteristics, industry conditions,
operating characteristics, and other factors believed by engagement partners to be signifi-
cant. Modifications to audit procedures as a result of risk reviews took place in minority of
cases (mainly for public clients), and usually with regard to management characteristics and
industry conditions (Mock and Turner, 2005, p. 73). Such modification typically resulted
in the employment of more experienced staff and procedural changes (73–4).
7. Summary and conclusions
7.1. Overview
The current position of public accountants with respect to the detection by corporate audi-
tors of MAM facilitated by DSM is that it is a limited responsibility couched in ambiguous
terms such as due care, proper scepticism, reasonable assurance, and reliance on man-
agement. In other words, by means of a historical combination of court case judgments
and professional pronouncements, corporate auditors are portrayed as reasonably care-
ful, skilful, and cautious individuals responsible for an attest function with boundaries.
More specifically, the current audit is a paradoxical one in which the corporate auditor is
expected to presume the honesty of senior managers when relying on their representations,
while concurrently recognising that DSM can use their position and authority to override
internal controls, coerce junior managers and employees, and induce compliant external
service providers in order to create the necessary conditions for MAM. Much is therefore
left to the corporate auditor’s assessment of individual circumstances and, in that respect,
the economic cost of MAM detection plays an important part in limiting the extent of audit
procedures. Public expectations about corporate auditor responsibility, on the other hand,
assume an unequivocal duty to detect MAM by DSM irrespective of cost.
The history of this complex and potentially damaging situation has its genesis in mid
to late nineteenth century court cases of fraudulent reporting in the UK. At this time, the
institutions of public accountancy were uninvolved in setting viable parameters for corporate
audit responsibility and much was therefore left to the opinions of individual legal counsel
and judges. The latter constructed an informal model of responsibility that appeared fair to
all concerned and yet was presumably viable enough to manage from a judicial point of view.
Almost inevitably, the model involved ambiguous and undefined legal terminology such as
reasonable care and skill in the circumstances that were used later by public accountants to
create their image of a reasonably careful, skilful, and cautious corporate auditor.
As public accountancy practitioners became more involved in corporate auditing, they
began to express their views on their responsibility for detecting corporate fraud generally
(thus logically subsuming the topic of MAM by DSM). The unstructured combination of
legal judgments and individual accountancy practitioner comments resulted in a model of
excuses with regard to the corporate auditor’s responsibility for fraud (and therefore MAM).
These excuses were used to either deny or limit this responsibility and were inherited by the
institutions of public accountancy when they eventually became involved in the production
of formal audit guidance and standards.
The effect of the above history has been current audit standards in the UK, US, and
elsewhere that use language first heard in nineteenth century British courts. More specif-
ically, public accountancy institutions created a relatively unchanging model of limited
responsibility based on excuses of the past expressed in vague and imprecise language
while retaining the image of a careful and competent professional. The consequence is a
persistent expectations gap between audit practitioners and beneficiaries, most obviously
highlighted when there is a corporate reporting and auditing failure involving MAM by
DSM. Public accountancy responses to such failures (particularly in the US) have been a
succession of audit standards in which the assessment of the risk of MAM is at the heart—but
without much regard to the related risk of DSM. The overall impression of these standards is
of a greater responsibility being assumed when, in fact, there has always been an acceptance
by public accountants (sanctioned by legal judgments) of a limited duty to detect MAM,
i.e. the strategy of doing “nothing.”
Arguably, the most significant problem in this respect is the lack of attention by public
accountants and their institutions to the presence of DSM when auditors are faced with
MAM. In particular, as argued in this paper, MAM cannot take place without DSM and yet
the corporate auditor is explicitly permitted to presume the honesty of senior managers in
the context of relying on their representations. Nowhere in audit guidance and standards
has there been discussion about the paradox of this situation and the potentially damaging
consequences if the auditor fails to detect MAM because he is over-reliant on the honesty of
senior managers. Past court cases involving MAM by DSM typically reveal the corporate
auditor over-relying on management and subsequent audit standards continuing to empha-
sise the need for both reliance and scepticism. Audit standards explain and discuss MAM
without focusing on DSM. In other words, the corporate auditor is educated and trained to
cope with MAM once detected but not trained and educated to identify the DSM with the
potential to commit MAM.
The historical evidence of this study suggests that the existence of DSM is a sign of
potential reporting difficulty. Whether this is always the case is a matter of conjecture.
But recall Argenti (1976) perceived a dominant CEO as a weakness when calibrating his
corporate failure-predicting A-score, and Heimann-Hoffman et al.’s (1996) warning signs of
fraud predominantly concern DSM. The problem for the corporate auditor is that, frequently,
DSM feature in highly successful companies. Perhaps the argument should be that, as
revealed in many of the cases described in this paper, DSM makes a bad situation worse and
corporate governance mechanisms less effective than they should be. More specifically,
again as revealed in this paper, the existence of DSM coupled with any of a number of
contributing factors such as boom economic conditions, lax internal controls, generous
executive compensation packages, and complex organisational and financial structures, may
determine the risk of MAM. Sacks (2004, p. 5), for example, identifies the typical breeding
ground for MAM, i.e. a corporate situation in which there is an autocratic management
style with a feared CEO, an iron-hand emphasis on money, short-term goals focused solely
on profit, intolerance of mistakes, and a high rate of employee burnout. She recommends a
need to “set the tone at the top” (5). Waddock (2005, p. 146), on the other hand, reflects on
senior managers bending to external pressures and expectations, and of business and public
accountancy leaders losing integrity. Klein (2003) discusses various institutional responses
to financial reporting and auditing failures that include strengthening corporate governance
with boards of directors and committees more independent (particularly with respect to
DSM).
What is most obvious from the analysis in this paper is that individual public accountants
and their institutions over many decades have preferred to focus on the symptoms of a disease
(e.g. technical weaknesses such as poor internal controls or the manipulation of accounting
standards) rather than the disease itself (i.e. DSM utilising complex organisational structures
and financial engineering and willing to tolerate weak controls and pressure employees).
In fact, public accountants have consistently placed the major responsibility for detecting
and preventing MAM on senior managers—the very individuals they are expected to rely
on for honesty. Pertinently, Waddock (2005, p. 147) concludes that:
The accounting profession seems to have failed to acknowledge that accounting is
fundamentally an ethical, rather than a technical, discourse.
In denying or limiting their responsibility for detecting MAM by DSM, public accoun-
tants appear to have made this failure explicit. They have failed to recognise the need for
corporate auditors to plan for and act against DSM as well as MAM. They admit they can
do so—but, hypocritically, only as a management advisory service. They claim to do so in
a limited way by assessing audit risk in relation to MAM. But they have never accepted full
and direct responsibility for dealing with the disease.
This paper argues for change in this respect, i.e. corporate auditors should be primarily
responsible for detecting MAM facilitated by DSM and that the focus for the successful
discharge of that responsibility should be assessing and planning for the degree of dominance
of senior managers in the context of the presence of other contributing factors such as
labyrinthine group structures and related internecine financial transactions that facilitate
dubious practices, including creative accounting.
7.2. Proactive and competent
Such a recommendation is not entirely new. For example, more than 30 years ago, Flint
(1971, p. 290), wrote of the need to be proactive:
Society is entitled to expect from the auditor an imaginative, penetrating, enquiring
attitude which is alert to the opportunities for irregularity in the particular circum-
stances; not solely waiting, however diligently, for the event which arouses suspicion.
Later, Humphrey et al. (1992, p. vii) observed that auditors should accept the public
expectation that they are responsible for detecting MAM. In particular, they criticised the
various excuses used by public accountants to deny or limit responsibility (13) while offering
separate specialist fraud services (14). However, if public accountants are to assume the
responsibility they have been denying or limiting for decades, they need to have sufficient
competence to assess the degree and type of domination by senior managers that is likely
to result in MAM. As Bevis (1962, p. 34) has remarked:
Effective auditing means requisite knowledge and skills on the part of the attester in all
important phases of the measurement, substantiation, and communication processes
which are involved. This includes the exercise of due professional care.
Competence also means that the auditor can maintain the independence required to
provide an objective opinion because he has the skills and experience to ask appropriate
questions of DSM and properly assess the reliability of the responses (Lee and Stone, 1995;
Taylor et al., 2003).
Waddock (2005) generally provides an argument that educators are failing to teach future
business and accounting leaders the ability to consider the consequences of their professional
actions with respect to corporate stakeholders and to take a wider perspective than the
economic advantage of their shareholders. She further argues that there is a need for a more
balanced approach to management and accounting, including an integration of perspectives,
holistic understanding, respect for diversity, and grasp of complex change (Waddock, 2005,
p. 149). The particular perspective and complexity of this paper is that DSM do not always
act with proper regard to stakeholders generally and, instead, prefer a narrower perspective
of economic advantage to shareholders (often including themselves in terms of service
contracts). Public accountants need education and training programs designed to identify the
possible effects of a complex combination of red flags that signal possible MAM by DSM.
Amernic and Craig (2004) provide a compatible argument for changing the education of
public accountants. They particularly criticise programs that produce technical accountants
rather than independent and challenging practitioners (Amernic and Craig, 2004, p. 347–8).
They further argue that there is a need to educate public accountants to understand the
political, ideological, and non-objective nature of accounting (and, presumably, auditing)
(350–8). In this respect, public accountants’ continuing efforts to deny or limit responsibility
for detecting MAM by DSM can be seen as an educational failure, i.e. a failure to understand
that public accountants as professionals have a public interest duty to protect stakeholders
from the dysfunctional consequences of DSM.
If public accountancy education is to change to permit auditors to assume the responsi-
bility for detecting MAM by DSM then programs must incorporate appropriate instruction
in the thinking and procedures necessary to identify and assess the various red flag warnings
of MAM and DSM. These red flags cover managerial characteristics and traits, contrac-
tual opportunities and incentives, complex organisational and financial forms, as well as
economic and operational conditions. To deal with these matters, more curriculum time
needs to be available for relevant aspects of economics, finance, law, management, and
psychology—perhaps at the expense of technical accounting and auditing matters. On the
evidence of recent corporate failures it has to be presumed that a reasonably careful, skilful,
and cautious corporate auditor would not necessarily identify red flags of MAM facilitated
by DSM.
After more than 150 years of accounting and auditing training, this is a situation that
must change if scarce corporate resources are not to continue to be lost to fraudulent activity
undetected by corporate auditors. Little of what is analysed in this paper is in itself new
or unknown. The legal cases have been reviewed in a variety of sources. The professional
responses to audit criticism have been fully debated. The expectations gap is a familiar topic.
The ambiguity of the corporate auditor’s responsibility for detecting MAM is a subject of
continuous reference. However, by bringing these matters together as a complete topic, by

connecting the pieces of the jigsaw into a complete picture, the historian “bears witness” to
decades of writing, comment, and debate (Jordanova, 2000, p. 204), and reveals an issue of
public importance—that the corporate auditor may be able to cope with MAM but is less
likely to cope with the DSM likely to commit MAM. The legal cases used in this study can
be argued to be unique to their circumstances and times. However, they can also be argued
to be high profile at the time of their discovery and, therefore, the publicly visible tip of a
much larger invisible iceberg. Identifying icebergs is a reasonable way of bearing witness
for the auditing historian.
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Critical Perspectives on Accounting 19 (2008) 677–711

The dominant senior manager and the reasonably

Emeriturs Professor of Accounting, The University of

∗ Corresponding author. Tel.: +61 2 93513107.

2. Accounting misstatement and dominant managers

2 The geographical limitations of the study are acknowledged.

3.1. Railway king

3.2. North British Railway Company

5 See also Valance (1955, p. 66–78).

4.1. City of Glasgow Bank

The CGB court-appointed trustees reported a capital deficit of £6.2m compared to a

4.2. Uncertainty about auditor’s responsibilities

8 See Kedslie (1990) and Walker (2004).

4.3. Model of excuses

4.4. Judicial decisions and accountants’ responses

(1838, 8 C & P 475) (Teo and Cobbin, 2005, p. 50).

4.5. London and General Bank and Kingston Cotton Mill

4.6. Capturing the audit market

4.7. American developments

In 1895, the Davey Departmental Committee on Amendments to the Companies Acts,

5.1. US professional regulation

5.2. Kreuger and Insull

The mid-to-late 1920s in the US featured out-of-control money markets, investment

12 See also Shaplen (1990) and Flesher and Flesher (1986).

resulting in such a complication of different enterprises that no accountant, however

From its founding as a collection of match companies in Sweden, KT diversified and, by

5.3. McKesson & Robbins

5.4. Formalising reasonable care

defalcations and other irregularities, and deliberate managerial misrepresentation.

6. 1961 to present day

6.1. Reid Murray Holdings

6.2. Thomas Gerrard & Sons

6.3. Equity funding

al., 1992, p. 53–5).

1974 established the Cohen Commission on Auditors’ Responsibilities to examine the

6.4. British position

6.5. Further American developments

6.6. Maxwell Communications

6.7. Bank of Credit and Commerce International

6.8. Institutional responses

6.9. America and elsewhere in the new millennium

6.12. Bond/Bell Resources20

19 Zekany et al. (2004, p. 102–4) reveal the importance of DSM in WC.

6.14. Institutional responses of public accountants

6.15. Practitioner responses

It is difficult to determine individual audit practitioner responses to situations such as EC

24 See also Barber (2005).

7. Summary and conclusions

7.2. Proactive and competent

continuous reference. However, by bringing these matters together as a complete topic, by

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