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The future of fraud

By: dmc-admin//June 28, 2006//

The future of fraud

By: dmc-admin//June 28, 2006//

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Coenen
Tracy L. Coenen

Massive frauds at companies such as Enron, Tyco, and WorldCom brought significant attention to the subject of fraud in public companies. The frauds became real as jobs were eliminated, investors lost millions of dollars, and families lost their savings.

Faith in the executives and financial statements of companies was rocked to the core. Regulations were implemented to help restore that faith and direct the business practices of companies. While the publicity and the regulations have altered the way companies do business, how significant is that effect and how long will the effect last?

The answer really lies in what the stakeholders of companies are willing to do about fraud. Will the shareholders and employees hold upper management to a higher standard than was necessary in the past? Or will they let executives run companies in a manner that is sometimes reckless, unchecked, and unaccountable?

While the companies with dishonest executives and fraudulent financial statements were few in number, the effects were still felt by many. The initial pain of the frauds was felt by those who had a direct interest in a company that had a fraud. This included employees, investors, and retirement fund participants.

Those who did not have a direct interest in one of the companies with the big frauds sympathized with those affected, but likely could not fully appreciate the impact.

Certainly, though, they recognized the potential to experience a fraud of their own in the future.

The pain of the big frauds has really worn off, however. While people still talk about the big frauds and acknowledge that significant ethical breakdowns were at the heart of the frauds, that’s not enough to stop them from happening again. Constant pressure on companies to mitigate the risk of fraud would be necessary to force companies to remain focused on good fraud prevention controls and protection of the investors.

Will a “big” fraud happen again? Will it happen sometime soon? My guess is that it will. Even with the newer regulations and the increased scrutiny on corporate governance and ethics, I don't think that we're immune to big fraud.

Pressure for Results

The pressure on executives to meet earnings expectations and increase stock prices certainly contributes to the potential for fraud. Sarbanes-Oxley, the 2002 legislation that increased corporate governance requirements for public companies, has certainly had an impact on fraud. It has helped to decrease the likelihood of fraud occurring in companies, although it’s impossible to measure how large the impact is.

While regulations can help the fraud situation, they do not remove the short-term pressure on executives to meet earnings targets. Constant market pressure to increase share prices is an overriding factor in companies, and may always overshadow the need for fraud prevention.

Investors are looking for return on their capital investments in the short-term, and this could push management to create aggressive and possibly unethical accounting practices to increase current earnings. Unless investors object to favoring earnings and share price ahead of fraud prevention, companies will not change their operational practices.

Compounding the problem is the fact that upper management compensation is often tied closely to stock price. The granting of stock options and awarding of bonuses increases the pressure for positive financial results. If financial targets can be met without extensive fraud prevention controls and policies, executives have essentially met the objectives laid out for them.

One further complication is the fact that greed is a part of human nature. Greed on the part of executives may lead to the manipulation of earnings. Stories abound of executives using public companies as their own personal piggy banks. From upper management buying lavish home furnishings on their employers’ dime to executives making huge sums from stocks traded with insider information, the temptation and opportunity to commit fraud may be overwhelming.

Legislating the Fraud Problem

Sarbanes-Oxley certainly has had its positive effects on companies, and has mandated some reforms that can give investors greater confidence in financial statements than they had prior to the legislation. In part, the act calls for the establishment of independent boards of directors, requires analysis and reporting on the status of a company’s internal controls, and mandates protection for whistleblowers. These are certainly welcome improvements.

Sarbanes-Oxley is not a fraud prevention tool, however, even though it has mandated these improvements. A meaningful, long-term reduction in fraud requires internal controls that actively prevent fraud. These controls need to go far beyond what is required by the legislation.

The current legislation has also increased prison sentences for executives engaged in fraudulent activities. However, these longer sentences are not likely to have a significant deterrent effect. An executive who commits fraud generally does so with the expectation that she or he will not be caught. Therefore, the executive is unlikely to compare old and new prison sentences when considering whether or not to commit fraud.

Even more important, however, is the fact that Sarbanes-Oxley will fail to change the behavior of investors. Even though it may improve the behavior of companies and executives to some extent, the legislation cannot stop investors from disregarding the information made available by companies.

History has shown us that investors are not necessarily logical, but rather emotional. They are therefore more likely to act based upon market conditions rather than corporate governance information released by companies. Investors will act based upon their enthusiasm for the market and rising stock prices.

Solutions for the Future

Pressure from stakeholders to act ethically is necessary to force companies to decrease fraud. If investors and employees became more vocal about the need for better preventive controls, how would companies carry out those mandates?

Increased audit activity is one option, although it may not be as effective as the average investor might be led to believe. Large public companies engage in millions of transactions each year, and auditors are unable to examine all of these transactions. Audits include testing of transactions, which means that only a very small number of transactions are actually examined. Therefore, detecting errors is difficult, and the detection of a fraud which is actively concealed by employees is even more difficult.

However, auditors can increase their effectiveness during an audit, even if the audit itself cannot really prevent fraud. Auditors must be more skeptical and must strongly resist suspicious and aggressive accounting policies of companies. A greater level of professional skepticism will mean more thorough scrutiny of management and operations.

One way to head off problems with executives managing for personal g
ain or engaging in inappropriate transactions is via executive transparency. Inappropriate transactions that put money directly into the pockets of unscrupulous executives leave paper trails that could be uncovered during annual examinations of the executives' personal finances. This examination could deter executives from committing fraud for personal financial gain.

Even with extensive examinations and effective internal controls, dishonest executives may always find a way to commit fraud. They can override controls or engage in even more creative practices to cover up theft. Only a shift in ethics and values could stop this. The greedy executive who wants to meet earnings targets cannot be stopped by even the best controls and examinations.

Until shareholders demand effective corporate governance, companies will not strive to do anything more than what the regulations require. If the shareholders, in conjunction with management and the board of directors, demand effective checks and balances from public companies, true fraud prevention can be sustained over the long haul.

Tracy L. Coenen, CPA, MBA, CFE, is the president of Sequence Inc, a forensic accounting firm with offices in Milwaukee and Chicago. She can be reached at [email protected] or 414.727.2361.

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