By Jaclyn Jaeger
While government officials congratulate themselves for a job well done since establishing the Corporate Fraud Task Force five years ago, experts tell Compliance Week that institutional fraud is still a rampant problem.
According to a corporate fraud report released in June by Oversight Systems, 76 percent of certified fraud examiners believe corporate deception has increased since 2002. The report also said that 56 percent of respondents have personally observed misconduct in the past year.The findings contrast with the 1,236 corporate fraud convictions that Deputy Attorney General Paul McNulty touted at a recent reception marking the fifth anniversary of the task force. Those enforcement actions included the convictions of 214 chief executive officers and presidents, 123 vice presidents, 53 chief financial officers, and 23 corporate counsels, McNulty said.
Of fraud schemes most often committed, revenue recognition is by far the most prevalent at 41 percent, according to SEC enforcement fraud research conducted by Frank Hydoski and Toby Bishop, co-directors of the Deloitte Forensic Center. The SEC enforcement releases covered 2002 to 2006.
Other fraud schemes involving manipulation of various financial statements account for more than one-third of all fraud schemes identified, Bishop and Hydoski found. Among the different ways that revenue recognition frauds are perpetrated, the recording of fictitious revenue represented the largest single component of those schemes.
The second most common recognition fraud was recognizing inappropriate revenue from swaps, “round tripping,” or bartered arrangements. Other types of revenue recognition fraud were evenly distributed, Bishop and Hydoski found.
In general, the popularity of fraud schemes is driven by factors such as how many companies are in a particular industry and how well established fraud controls are in an industry, says Bishop, who is also former president and chief executive officer of the Association of Certified Fraud Examiners.
“If fraud were being committed at the same rate in every industry, the number of individual fraud schemes identified would still vary based on the number of companies in that industry,” he says. A second belief is that the older an industry is, the more likely it has fraud controls in place.
For example, Hydoski says, the technology, media, and telecommunications industry has the highest percentage of identified fraud schemes (39 percent) possibly because it is so young and presumably has less developed internal controls.
Another cause of fraud can be the amount of pressure an industry puts on people to perform at high levels, says Tracy Coenen, founder and president of Sequence, a forensic accounting firm. “That is a very big factor,” she says. “When you have an upper-level executive of a company, [his] job is to see that the company does well [and] manages money well, so naturally it can be very tempting if your job is on the line, or if a bonus is on the line, to want to manipulate the figures to keep that job or get that bonus.”
A recent study on financial misrepresentation published in the academic journal Organization Science supports that theory. In that study, the authors examined hundreds of financial restatements prompted by accounting irregularities identified by the Government Accountability Office. The GAO identified 919 such restatements announced between January 1997 and June 2002, resulting from ” aggressive accounting practices, misuse of facts, and fraud.”
One factor that substantially increases the likelihood of financial fraud is that firms performing poorly against industry peers also tend to misrepresent their financials, says Jared Harris, a business professor at the University of Virginia and an author of the study.
That conclusion may not be surprising, says professor Philip Bromiley of the University of California at Irvine, who also authored the study. What does raise eyebrows: even firms that have had an incredibly good year tend to cheat, he says.
“We suspect that good year has raised expectations beyond what they could ever do,” Bromiley says. For example, if a firm normally yields 10 percent on assets and happens to have one good year where it hits 35 percent, “the market may expect them to stay at that mark,” says Bromiley. “The odds are quite good that they can’t do that.”
Companies must also be mindful that multiple fraud schemes often unfold at the same time, says Hydoski. That makes fraud risk assessments especially important because “controls for one type of fraud may not help one with another type of fraud, or an investigation into one type of fraud may or may not uncover the other frauds that are being conducted,” he explains.
“So organizations need to be mindful of multiple different fraud schemes as being possible concerns and design their anti-fraud measures to address that varied risk,” Bishop adds.
A pillar of anti-fraud efforts is good segregation of duties, to create a system of checks and balances over company employees, Coenen says. “If employees are naturally checking one another’s work and checking one another as far as proper authorization to spend money or entering transactions, those types of things help to cut down on fraud.”
The weakness in that tactic, however, is that employers must trust their employees, says Coenen. “If you have an upper-level executive who has power over a lot of people below them, you can have all the checks and balances in place that you want, but that CEO might go to a lower-level employee, and say, ‘We’re not following this procedure. This is what I want you to do instead.’ That employee is often put in a position of, ‘Do I listen to the boss or not?’”
A strong board with an active audit committee can help prevent such management abuses, but Harris also contends that tactic is not always true. According to his study, “practices typically considered measures of ‘good governance,’” including independent board members and institutional stock ownership, had no effect in deterring misconduct.
“I would never suggest that board composition and institutional ownership don’t ever matter,” says Harris, “but in this body of data, whatever the potentially positive effects these governance practices may possess, they were completely overwhelmed by the motivating power of incentive pay and poor performance.”
One “exciting area” of increasing development is new fraud detection techniques supported by technology, Hydoski says. Historically, most fraud has been discovered accidentally by auditors, employees, or whistleblowers through transactions that can’t otherwise be explained.
Today, however, there’s been greater interest in monitoring-type software designed to spot possible fraudulent transactions, which will probably see “pretty significant developments in the not so distant future,” Hydoski predicts.
But technology, too, isn’t without its flaws. “There’s probably an inherent lag between when a fraud scheme comes out versus when technology to address it comes about,” Hydoski says. “A person who is seeking to commit a fraud is not gong to do it in a transparent way, so they’re probably going to try to mask the fraud in various ways.”
For that reason alone, it’s impossible to say just how many people commit fraud. “The one thing we can be sure of, it’s more than are caught,” Bromiley says. “Think of the number of people who speed relative to the number of speeding tickets that police issue.”
At most, certain types of fraud can only be stopped when they become known. “I think many people put general controls in place, and as particular fraud schemes become apparent that are not being addressed by specific fraud controls, general controls may be adapted, customized, or advanced,” says Bishop.