THE ANTI-FRAUD COLLABORATION recently published a research report titled “The Fraud-Resistant Organization: Tools, Traits, and Techniques to Deter and Detect Financial Reporting Fraud” that identifies the conditions that could make an organization more susceptible to financial reporting fraud and provides related actions that can mitigate those conditions.
Formed in 2010, the Anti-Fraud Collaboration is focused primarily on large public companies with widely scattered operations, but the principal lessons of its report are scalable and can apply to organizations of all sizes and types. “The Fraud-Resistant Organization” suggests conditions that allow financial and/or tax reporting fraud to exist, including:
- Lack of a strong ethical culture throughout the organization that’s encouraged through word and deed by a strong tone at the top.
- Insufficient skepticism or over-optimism in the oversight provided by members of the financial reporting supply chain, including management, the board of directors, audit committee, and internal and external auditors.
- Insufficient communication among members of the supply chain. Less-senior participants fear retribution if they report or speak out about some of their ethical concerns. Whistleblowing still isn’t a protected activity in many situations and may result in retribution.
SUSCEPTIBLE TO FRAUD
The report cites KPMG’s Integrity Survey 2013 research, which found that 64% of employees involved in fraud were managers or members of senior management and that the CEO was involved 26% of the time. Weak internal controls were exploited in 74% of the cases, and 61% of the cases involved collusion. Previous research had somewhat similar results. In May 2010, the Committee of Sponsoring Organizations of the Treadway Commission’s (COSO) Fraudulent Financial Reporting 1998-2007, a study of the Securities & Exchange Commission (SEC) enforcement actions regarding frauds in public companies, found that 72% of the cases involved the CEO and 65% involved the CFO.
One significant reason that senior management is frequently involved in fraud cases is that often a portion of their compensation is based on reported results. More than two-thirds of the 3,500 U.S. employees surveyed in KPMG’s Integrity Survey 2013 cited “pressure to do ‘whatever it takes’ to meet business goals” as the prime driver of misconduct, more than any other cause. In COSO’s analysis, the most commonly cited motivations for financial reporting fraud were “the need to meet internal or external earnings expectations, an attempt to conceal the company’s deteriorating financial condition, and the need to increase the stock price.
Three central themes are critical to fraud deterrence and detection, according to “The Fraud-Resistant Organization.” To some extent, they all involve aspects of a strong ethical culture: an action-based commitment to ethical behavior from top management, increased skepticism and a questioning mind-set, and robust communication from all those involved in the financial reporting process.
It’s imperative that the strong commitment to ethical behavior from top management is supported by actions as well as words. It has been shown time and again that merely enacting a formal code of ethics is insufficient to prevent ethical wrongdoing. Enron’s voluminous code, for example, was widely known to be window dressing and didn’t truly guide conduct. And more than half the employees surveyed in the KPMG Integrity Survey 2013 had observed misconduct in their organizations in the previous 12 months, with 60% of those reporting that they believe that the code of conduct not being taken seriously is a major driver of misconduct.
Skepticism is well known as a fraud deterrent in auditing standards, but it also has an important place in financial reporting. The characteristics of skepticism apply to individuals at all levels of the accounting profession:
- A questioning mind, suspension of final judgment, and the search for additional knowledge and support lead accountants to look at all aspects of economic activity and not just accept the obvious first answer or what someone in authority says.
- Interpersonal understanding helps accountants recognize that people’s perceptions and motivations for a particular conclusion can be biased.
- Integrity and conviction to decide for oneself, combined with self-confidence, enable accountants to decide and investigate issues themselves rather than immediately accept the claims of others.
Finally, robust communication among participants in the financial reporting process is an important aspect of fraud deterrence and detection. In my view, it’s the natural result of a strong ethical culture, but it’s still worth highlighting. Understanding any additional facts that support accounting conclusions can help prevent or avoid the suspicion of wrongdoing when there isn’t any improper or unethical behavior. In other words, increased communication helps everyone involved have a greater understanding of the reasoning and evidence that drive accounting decisions and conclusions. Thus there’s less guesswork and supposition when trying to understand motives.
Although the primary audience for “The Fraud-Resistant Organization” appears to be the oversight participants in the reporting process—including corporate directors, audit committees, and external and internal auditors—its message can resonate with accountants in business, industry, and not-for-profit organizations as well.