• Embed Doc
  • Copy Link
  • Readcast
  • Collections
  • CommentGo Back
Download
 
FRAUD DETERRENCE 
Carl Burch, CMA, CIAFinance and Accounting LecturerMoscow, RussiaCburch@global.t-bird.edu
“To find fraud, one has to know what it looks like. To stop fraud, one has to know what causes it.” 
1
In criminal law,
fraud
is “a crime that entails deliberately deceiving another in order to damage them.” Thereare almost as many types of fraud as there are types of people who commit fraud. The most important thingto remember about fraud is that every company is at risk of being defrauded. Because of this, it isimperative for companies to understand the risks of fraud and how to protect themselves against fraud.In this article we want to focus our attention on fraud that is perpetrated against a company. This type of fraud is more commonly referred to as
Occupational Fraud
.By definition,
Occupational Fraud 
is “the use of one’s occupation for personal enrichment through thedeliberate misuse or misapplication of employing organization’s resources or assets.” As we can see, thisdefinition can, and does, include every employee within an organization, from the top executives all the waydown the reporting line. Occupational fraud can vary from very sophisticated investment schemes, like theone committed by Nick Leeson against Barings Bank,
2
 or it might simply be the theft of petty cash. Butwhatever the fraud and no matter how small it may seem, the act is wrong.Before going any further we first want to discuss the three main categories of occupational fraud. They are:1)
Fraudulent Financial Statements.
Fraudulent financial statements are financial statements thatare intentionally misstated in order to mislead users. The general users of financials includemanagement, financial analyst, shareholders, suppliers and others.2)
Asset Misappropriation.
Another word for asset misappropriation is “stealing.” Assetmisappropriation includes theft of any assets, or any other action that causes the company toexpend cash or other assets for things that will not benefit the company.3)
Corruption.
Corruption includes illegal gratuities, brides and kickbacks, conflict of interest, andeconomic extortion.These three branches of fraud are shown in
Appendix A
at the end of this article. This fraud tree chartgives a detail breakdown of the type of activities related to each branch.The accounting scandals that have occurred in the US and elsewhere the past few years are examples of occupational fraud. These scandals involved some of the worlds largest business, i.e., WorldCom, Enron,Parmalat (Italian milk processor), Adelphia, Tyco and many others.
So what was the affect of these scandals? 
Taking just Enron and WorldCom; these two companies filedbankruptcy totaling more than $170 billion in assets ($107 billion for WorldCom and $63.4 billion for Enron).Think of the affect these bankruptcies had on thousands of people, either through lost jobs or lost pensions.In addition to the direct financial consequences, these bankruptcies also damaged the public’s confidencein the financial markets.Unfortunately too often it’s only after a crisis that a government will take action to help prevent fraud.Largely as a result of a series of accounting failures that were fraud related, the US government passed theSarbanes-Oxley Act (SOX) of 2002.The primary purpose of SOX was to:
1
Internal Auditor, December 2007, pg. 63.
2
Nick Leeson was a former derivatives trader for Barings Bank, whose unsupervised speculative trading caused the bank to collapse in 1995. At the time, Barings Bank was the UK’s oldest investment bank.
1
 
Improve quality and transparency of financial reports and independent audits and accountingservices for public companies,
Enhance the standard setting process for accounting practices,
Strengthen the independence of firms that audit public companies,
Increase corporate responsibility and the usefulness of corporate financial disclosure, and
Protect the objectivity and independence of securities analysts.SOX must be followed only by publicly traded companies that are registered in the US. Surprisingly,however, even private companies are now trying to implement some of the recommendations of SOX.Particularly in areas having to do with the audit committee and internal auditors. Whether public or private,all organizations realize that the importance of having strong internal control procedures.
Committing Fraud
Now, we want to move on and discuss what motives a person to commit fraud. In order for fraud to becommitted, three conditions need to be present.
1.
The person has be
motivated
to commit the fraud,
2.
The person has to have the
opportunity
, and
3.
The person has to have the ability to
rationalize
his or her behavior.We will now look at each one individually in more detail.
Motivation
The motivation is the reason behind the fraud – the reason that the individual chose to commit fraud. Thereis no single reason why a person commits fraud, but some of the more common factors include:1)Internal pressure from top management to meet other’s expectations (e.g., market or revenueexpectations, etc.). Not meeting their expectations could lead to job loss or demotion.2)External pressure from financers that threatens the organization’s financial stability. For example,not meeting various requirements in a debt agreement, etc.3)Pressure to pay for a personal lifestyle, and or vices (i.e., gambling, drugs, etc.).4)Pressure to maximize bonuses or compensation when it is performance based (e.g., the companyhas a contingent compensation structure, etc.)
Opportunity
Simply having the desire to commit fraud will not allow a person to commit fraud if they do not have theopportunity to do that. Without opportunity, fraud could not, or would not be committed.Some of the factors and conditions that enable an individual to have the opportunity include:1)The knowledge of the weaknesses of the company’s internal control systems,2)Access to accounting records or assets,3)Lack of supervision,4)Unethical “Tone at the Top,” and5)Belief that the person will not get caught.
2
 
Ultimately, it’s up to management to understand the opportunity factors that could lead to fraud beingcommitted in a company and then to minimize the risk of fraud by reducing the opportunities that exist for fraud to be committed.
Ability to Rationalize Behavior 
The last factor that has to be present in order for fraud to be committed is the ability of the person torationalize his or her behavior. Unless you can rationalize your behavior, you will not commit fraud – even if you have the motivation and opportunity. Quite simply what you are doing here is convincing yourself thatthere is a perfectly acceptable reason for what you are doing. The sense of ethics, morality and the idea of right and wrong is what prevents some individuals from rationalizing this behavior.Some examples of rationalization are:1)The individual believing that they have not been properly compensated for their work. They believethe company owes them something for work that they have done in the past, and therefore, stealingmoney is not stealing, but just getting what is rightfully theirs.2)Not getting the recognition an individual feels that they should be getting.3)Needing more money in their personal life.4)Or, perhaps the individual is able to justify the theft because they plan on returning the money in thefuture.Again, without some form of rationalization, together with the motivation and opportunity to commit fraud,fraud is not going to be committed.
Fraud Deterrence
Now, that we have gone over what fraud is and what causes people to commit fraud, we want to turn our attention to what companies have to do to deter or mitigate the risk of fraud. This is one of the mostimportant responsibilities for management in setting up the internal control system.Unfortunately, no matter how hard a company may try and as much effort as they put into this process, it isunlikely it will ever be able to guarantee that they have eliminated the risk for fraud. In short, this is becausepeople may work together to get around the system and its controls, or intentionally avoid the controls thatare in place. The two main inherent risks that all companies face are
collusion
and
management’soverride of controls
.
Collusion
is where two or more employees get together to commit fraud. Even if there are proper segregations of duties, that segregation of duties will not be effective if the people whose duties aresegregated work together.
Management’s override of controls
occurs when management simply ignoresor orders others to ignore the controls that are in place. Studies have shown that in cases of fraudulentfinancial reporting, management has consistently been able to override systems of internal accountingcontrol.
Given these inherent risks, what can companies do to deter fraud? 
Fraud deterrence and prevention starts by being
proactive
in the way the company approaches fraud -trying to prevent fraud before it occurs. When looking at potential fraud in your company, you have to askyourself if management is truly serious about trying to deter fraud, or is it just talking about it without reallyintending to do anything. Fraud deterrence requires that the company persuade individuals not to commitfraud in the first place because of the likelihood of detection and punishment for those who do commit fraud.We have identified three proactive components of a fraud deterrence program that are very beneficial in theprevention and deterrence of fraud. These three components are:1)Having an effective internal control system set up by management,2)Establishing a whistleblowing program, and3)Identifying fraud risk.
3
of 00

Leave a Comment

You must be to leave a comment.
Submit
Characters: ...
You must be to leave a comment.
Submit
Characters: ...