The Gauge of Innocence

These days, those who seek to deceive must also contend with a Securities and Exchange Commission that, under new chairperson Mary Schapiro, has placed a renewed emphasis on fraud detection, no doubt stung by its failure to unmask Bernard Madoff despite ample warning. "Those who break the law and take advantage of investors," Schapiro warned in February, "need to know that they will face an unrelenting law-enforcement agency in the SEC." She promises her agency will pursue lawbreakers "until the full force of the law is the sure, certain, and sole reward of their wrongdoing."

Preventive Measures
Within the workplace, "occupational fraudsters are generally first-time offenders," cautions the ACFE. In its 2008 report, it found that a mere 7 percent of perpetrators had prior convictions, and only 12 percent were let go by previous employers because of charges related to fraud. This data reinforced similar results in 2006 and 2004.

Luckily, most first-time embezzlers do not cover their tracks very well. Many flaunt their illegal gains. In 39 percent of cases it reviewed, the ACFE found that perpetrators lived beyond their apparent means. A third of them had financial difficulties when they committed fraud. Thanks to such flagrant signals, whistle-blowers tipped off authorities to nearly half of all occupational frauds.

Not that companies can afford to simply wait for anonymous tips. Monitoring sensitive activities and enforcing well-communicated antifraud policies play an important role in preventing lapses from becoming crimes. The goal should be to arrest bad judgment before it becomes fraud, says fraud-prevention expert David Dixon of Norkom, and to use coaching as a way to keep certain employees on the right track. Such actions might have shut down unauthorized trading at Barings Bank, says Dixon, long before the once-venerable British financial institution was taken down in 1995 by the reckless actions of a single trader. But for want of a coach, Barings was lost.

"If you test the waters and see that nobody is watching, you will go ahead and pursue a fraud further," warns managing director Ken Yormark of LECG, a firm that conducts fraud investigations around the world. "If you have the right controls in place and someone says stop, you quell the urge. Stamping down that desire is the number-one way to prevent fraud."

Also key is continuous research into ways to ferret out fraud. One recent study used nonfinancial data to sniff out anomalies that may indicate fraud; for example, if growth in retail outlets, warehouse space, or employee head count doesn't map logically to growth in reported revenues, something may be afoot, particularly when one company's metrics don't seem to parallel its industry peers. "You'll see a ton of red flags at fraud companies," says Joe Brazel, an assistant professor at North Carolina State University who co-authored the study.

Some experts have applied game theory to assess the potential for financial-statement fraud. In one study, three levels of "strategic reasoning" consider widening circles of actors and motives and how added scrutiny may alter behavior.

But drop any thought of using personality tests to sound the alarm on future manipulators of financial statements, declares Richard Davis, a consultant with RHR International, a corporate-psychology firm. "They're easily faked," he says. "There is no psychometric way to measure integrity." He is more sanguine about new methods involving microexpressions, very brief facial expressions that may reveal a person's predisposition to fraud.

There is, however, at least one psychological trait that can be a useful indicator. Beware of perfectionists, Davis warns. "The classic example is Martha Stewart." Hiding the fact of a conversation with a broker, not the substance of the conversation, sent her to prison, says Davis. "She wanted to appear as if nothing was wrong, so she masked small things to appear perfect."

There may be a lesson there for CFOs: set realistic expectations. For all the new research into fraud prevention, experts are unanimous about one thing: "tone at the top" counts for a lot. That was a vital finding of the National Commission on Fraudulent Financial Reporting, aka the Treadway Commission, in 1987. "The tone set by top management," the commission concluded, "is the most important factor contributing to the integrity of the financial-reporting process."

Think of tone-at-the-top as a beacon that can help prevent employees who toil in gray areas from crossing over to the dark side. Nothing will eradicate fraud, and in this current climate the fraud triangle may loom as large as an Egyptian pyramid. But CFOs can help keep this risk in check through a combination of clear communication, leading by example, and maintaining a watchful eye across the entire organization.

S.L. Mintz is deputy editor of CFO.

Fraud Facts

• Average length of time from fraud start to detection: 2 years

• Frauds exposed by whistle-blowers: 46%

• Corporate-fraud victims that blamed lack of adequate controls: 35%

• Companies that modified controls after fraud was detected: 78%

• Frauds by persons in the accounting department: 29%

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