6.4 Red Flags in Management Culture, Strategies, and Practices

Analysis of corporations that have experienced major ethical and financial difficulties shows these companies have a great deal in common in terms of their corporate culture and management profiles, as well as their accounting and governance practices. On the basis of this knowledge, we can identify a number of early warning signals or red flags that boards can use to spot the emergence of a corporate environment and culture susceptible to conflicts of interest and management abuse. For a suggestive list, see Chapter 13 "Appendix B: Red Flags in Management ".This section is based on Wood (2005).

Individually, these factors may not be predictive of future problems. In groups, however, they define a heightened risk profile and should be cause for additional scrutiny and objective analysis. For example, the combination of aggressive management practices creating rapid short-term revenue and stock-price growth coupled with weak board oversight, allowing the CEO to rapidly accumulate personal wealth through stock-based incentive compensation, has been present in a significant percentage of recent problem situations. Risk of rapid financial deterioration in such cases is exacerbated when the company also operates with aggressive financial practices and high leverage.

Audit committees would be well advised to monitor these categories of higher risk characteristics based on their proven usefulness in identifying corporate environments that may be susceptible to rapid stock price and credit deterioration, as well as fraud.