Risk Management

The Gauge of Innocence

Fraud takes many forms. Count on all of them to increase this year.
S.L. MintzApril 1, 2009

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.”

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%

• Frauds by executives or upper management: 18%

• Frauds by perpetrators living beyond their means: 39%

• Frauds by perpetrators experiencing financial difficulty at the time of the fraud: 34%

Thou Shalt Not Commit Fraud

Employees can resist everything but temptation.

Who might cheat? Talk to Dan Ariely, author of Predictably Irrational: The Hidden Forces that Shape Our Decisions, and he’ll tell you practically anyone. In a series of behavioral tests, Ariely and two colleagues tempted more than 2,000 people to cheat. Most did, despite Ivy League pedigrees and not much to gain.

Behavioral psychologists blame a trait called “reframing,” in which someone about to cheat adjusts the definition of cheating to exclude his or her actions. “People who would never take $5 from petty cash have no problem paying for a drink for a stranger and putting it on the company tab,” says Ariely, the James B. Duke Professor of Behavioral Economics at Duke University.

To measure the inclination to cheat, Ariely posed 10 questions about science and culture to groups of college students and paid them 10 cents per correct answer. Control groups gave their answer sheets to proctors. Subsequent groups had increasing leeway to cheat. One group could alter answers before turning them in, another could self-report the number of correct answers, and a third group could simply take 10 cents per correct answer from a jar without reporting results.

Control groups averaged 32.6 percent correct. Scores increased for the other groups, suggesting cheating, but not in strict accordance with increased opportunity. For example, the group allowed to change its answers had the highest scores, at 36.2 percent correct, while the group that paid itself directly cheated slightly less, and the group that self-reported to proctors cheated least.

Clear standards, Ariely says, provide a powerful deterrent. Prior to answering questions, one group was asked to name 10 books they had read, while a second was asked to name as many of the Ten Commandments as they could recall. Both had the opportunity to cheat; scores suggested that those who recalled the Ten Commandments did not. Likewise, no cheating was evident by MIT students who signed, in advance, a statement defining the study as falling within the university’s honor system.

“What this means for CFOs,” says Ariely, “is that they should think very carefully about the culture they want to create, and understand that it will have a big effect on what people will be willing, and not willing, to do.” — S.L.M.