April 5, 2010
Fraudsters thrive as honesty abates (Albuquerque Journal)
By Winthrop QuigleyUniversity of New Mexico accounting professor and certified fraud examiner Richard G. Brody has some depressing news.
American businesses lost almost $1 trillion to fraud in 2008, the amount of fraud is increasing, people are in general less honest than they were, and fraud is very difficult to detect once it has occurred.
"Many investors have lost confidence in the credibility of financial statements and corporate reports," Brody told a recent meeting of the CFA Society of New Mexico, a statewide association of chartered financial analysts.
Financial analysts have to assume the numbers they work with are honest. "The honest thing is we don't know if they're accurate," Brody said. When a fraud involves the financial statement of a publicly traded company, the resulting market decline in the company's value is typically between 500 and 1,000 times the amount of fraud itself, he said.
"It's everywhere," Brody said. "It ranges from people stealing office supplies, people stealing inventory, people paying fictitious vendors. Companies who think they don't have it are kidding themselves."
When fraudsters are caught their usual defense is that they didn't commit fraud intentionally or that they didn't know what they were doing was wrong.
"We tend to be very trusting," Brody said. "It's always the person we least expect. Always." That trust is a reason companies don't like to implement controls to prevent fraud, especially if they are a family company.
"The other side of trust is greed. It's the greed of investors that causes them to be taken. If you buy a weed whacker you do all kinds of research. When I tell you I can get you 35 percent returns and I have a nice PowerPoint presentation and people standing on stage with me saying that they made money and can show you the checks they received, you fork your money over."
Profiling fraudsters
Surveys of certified fraud examiners like Brody attempt to create a profile of fraudsters. The surveys, which Brody discounts as proving little, say the typical fraudster is older and has been with the company he cheats for a while. Fraudsters are mostly men, but the number of female fraudsters is growing, probably because more women have reached positions where they can commit fraud. Fraudsters will typically be higher up in the organization, and they often have a religious affiliation, possibly to keep up a facade of respectability.
Brody thinks the truth is simpler. "We don't have a profile," he said. "If you want to know what a fraudster looks like, look at the person next to you."
Fraud occurs when three elements come together. Someone has to be motivated to commit fraud, the work situation leads him to believe he can get away with fraud, and he is able to rationalize his own fraudulent behavior.
About 95 percent of all fraud is a result of financial pressure or an attempt to finance a vice like gambling. Some fraud is the result of work-related conflict, such as dislike of the boss or a sense that the fraudster has been cheated by the company. Some fraudsters are simply trying to support a lifestyle they can't afford on a salary alone.
"People with a higher level of integrity are definitely less likely to commit fraud, but everyone has a breaking point," Brody said.
People rationalize their fraud in a lot of ways. When a company fiddles with the books to please investors, it sometimes justifies its fraud by convincing itself the books will be repaired when a temporary financial problem is overcome, Brody said. People say they are only borrowing the money, they might think they deserve it, or they will steal to take care of a family emergency, like a sick child.
A culture of fraud
Management can create environments where fraud is more likely. They don't recognize performance, they have unreasonable budget expectations, they offer unrealistically low pay, they don't train their people, communication is poor, management is indifferent to employee concerns and work conditions.
Fraud is almost always detected through tips from employees, customers, suppliers, even competitors. "It is very rarely detected by auditors," Brody said. "The fundamental nature of auditing is not to detect fraud. I'm not sure there is anything an auditor can do."
It isn't that auditors are in bed with management. Auditors don't verify documents and they don't look at every document, only samples of documents. A fraud examiner will see if the company that sent or received an invoice actually exists. He will learn what that company supposedly does for a living and will determine if the invoice reflects that.
The best way to detect fraud is to look at behavior, not records, Brody said. Records will show anomalies, but people in the organization notice things – that someone is driving a car that costs much more than you'd expect someone in his position to be able to afford, for example. "There are always in a company people who are aware of these things." Lots of people in an organization will have a sense that a co-worker has a drinking problem or family financial problems. Fraud examiners trying to identify who has been stealing from a company might see if any employees are in the habit of using an ATM machine at the local casinos.
Preventing fraud
To prevent fraud companies need to create a culture of honesty, they need to assess the risks of being victimized that they are running, and they need to take concrete measures to address each risk.
"It's hard to hire honest people," Brody said. But interviewers can be trained to verify details of a resume. When the candidate is made a job offer the company can require that he sign a letter swearing that the information on the resumé is accurate.
Companies can provide employee assistance programs to help people overcome short-term emotional and personal crises. Work environments fare better when they're open, when communication is encouraged, when management's doors really are open, when employees' concerns get a real hearing.
Management needs to create a code of conduct, foster regard for the code's values, train people on what it means and how to live it on the job. "You have to live the code, and it begins at the top," Brody said.
Violators have to be punished consistently. "That's a two-edged sword," Brody warned. When a fraudster is punished, it can scare customers and suppliers, and when media report on the fraud the company can lose some reputation and market share.
Employers need to give employees a mechanism to report fraud. Companies should have an in-house fraud hot line.
Most companies wait for a fraud to occur and fix the specific problem when fraud is detected, but few have an overall plan for dealing with fraud company-wide before it occurs. It can be time consuming and expensive, but the company needs to identify the risks it's running, then identify what sorts of red flags are likely to pop up if someone is committing fraud, Brody said.
Even at that, he said, "Every system can be beaten."
The consequences can be fatal to a company or nonprofit organization, he said. It takes an average of 24 months to detect fraud, long enough for some companies to collapse from the rot within.