In tough times, companies face plenty of honest challenges, and most managers and staffers rise to the occasion. But inevitably, as pressures multiply, some will cave in and demonstrate poor judgment, or worse. They may blur the lines on revenue recognition, tinker with stock options, abuse reserves, or evade loan covenants. Petty favors from vendors or "innocent" side deals with customers snowball into grand larceny.

Pay cuts, layoffs, diminished morale, and fewer resources devoted to internal controls are among the specific pressures that "open the door to fraud in a down market," says Kerry Francis, chairman of Deloitte Financial Advisory Services, the accounting firm's U.S. fraud investigative arm.

She began emphasizing such concern in early 2009, after a Deloitte survey found that two-thirds of 1,280 financial-services and technology executives expected to see more instances of accounting fraud.

Since Francis first sounded that alert, the downturn has become vastly more severe. Stunning Ponzi schemes at Stanford Group (allegedly) and Madoff Securities have made fraud a key theme of the current economic morass.

CFOs can't be expected to peer into the souls of every employee or business partner, of course, but they do need to be more cognizant than ever of the three sides of the classic "fraud triangle": pressure, opportunity, and the capacity to rationalize. When those elements unite, fraud often erupts.

The perpetrators are frequently those you would least suspect, says Dan Ariely, author of Predictably Irrational: The Hidden Forces that Shape Our Decisions. Repeated behavioral testing shows that people cheat if they can get away with it — even smart, Ivy League–educated people with relatively little to gain (see "Thou Shalt Not Commit Fraud" at the end of this article). "The moment you have a fuzzy environment," Ariely says, "the more this can happen." In finance, recessions are very fuzzy. "CFOs are on shaky ground," warns Ariely, "because they are [now] operating in very difficult conditions."

For every case that makes headlines and ends with prosecutions, thousands of garden-variety frauds quietly drain corporate assets. The costs can cripple small and large companies. According to one unscientific estimate — a 2007–2008 survey of certified fraud examiners by the Association of Certified Fraud Examiners (ACFE) — U.S. organizations may lose 7 percent of their annual revenues to fraud, including financial-statement fraud.

Some fraud is flagrant crime, of course, but in other cases it can be thought of as good intentions gone badly awry. "The pressure can be enormous," warns Michael Young, an attorney with Willkie Farr & Gallagher and editor of Accounting Irregularities and Financial Fraud: A Corporate Governance Guide. "Insiders don't have crystal balls. All they know is that business has turned south and that that is not what outsiders are expecting. It presents almost a petri dish of temptation to meet expectations through some kind of accounting adjustment." That's often fatal, Young notes, because prosecutors and plaintiffs' lawyers pay close attention to evidence that performance targets or objectives influenced reported results.

No Stop Signs
As outlined by the ACFE, fraud can be classified into three broad categories: asset misappropriation (such as false invoicing, payroll fraud, or skimming), corruption (bribes, extortion, conflicts of interest), and financial-statement fraud, which aims to make companies look healthier than they actually are.

The first category is the most common, but the least costly (averaging $150,000 per incident). Fraudulent statements are the least common form of fraud, but in the ACFE study they accounted for a stunning $2 million median loss (as measured by lost market capitalization in most cases). Perhaps of most concern to CFOs, statement fraud is the very kind that can begin with an employee trying to "help the team," but in a misguided way. "There is no stop sign that will tell you when you are going too far," warns fraud-prevention expert Geoffrey Kaiser of Navigant.

In fact, there have been times when "too far" was seen as a virtue. In his 2001 memoir, former General Electric CEO Jack Welch bragged that GE managers once volunteered to help plug an unexpected $350 million write-off after a quarter's books closed. "Some said they could find an extra $10 million, $20 million, and even $30 million from their businesses to offset the surprise," Welch wrote.

By 2002, a culture shift had made earnings management more likely to garner prosecution than praise, and by 2005, when Waste Management was hit with a $26.8 million fine, plus other penalties, for "fraudulently manipulat[ing] the company's financial results to meet predetermined earnings targets," the practice was widely condemned.

Today, "any company obsessing over analyst earnings expectations needs to have its head examined," says Willkie Farr attorney Young. "Now the temptation is not to try to maximize earnings or meet expectations," he says. "It is to avoid impairments or other asset write-downs that put companies in a downward spiral toward bankruptcy."

These days, with shareholder expectations decidedly lower, lenders are emerging as the entity that must be pleased — or deceived. How easy is it to justify a dubious accounting step that averts a technical violation of a loan covenant and keeps a crucial credit line open? Put it this way, says consultant Michael Mayer of CRA International: "Companies that are facing significant covenant violations, or that need to raise capital, are under more pressure than ever."

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