Tag Archives: audit committees

It’s a Reputation Thing

According to the ACFE presenter at one of our live events, 6.4 percent of worldwide fraud cases occur in the education sector, which represents the fifth most-targeted industry by fraudsters out of 23 reported by members of the ACFE. And the three most frequent fraud schemes reported as perpetrated in the education sector are billing schemes, fraudulent expense reimbursements and corruption schemes. Most of the reporting CFE’s also seem to agree that nonprofit institutions’ greatest fraud related challenge is mitigating reputational risk. Good faculty members and students won’t join fraudulent universities. Governments and donors won’t financially contribute to organizations they don’t trust.

Thus, institutions of higher learning aren’t anymore immune to fraud than any other large organization. However, the probability of occurrence of fraud risks may be somewhat higher in colleges and universities because of their promoted environment of collegiality, which may lead to more decentralization and a consequent lack of basic internal controls. Federal and state governments, as well as donors, have increased the pressure on universities to implement better governance practices and on their boards of governors to exercise their fiduciary responsibilities more efficiently.

Which brought our speaker to the issue of regular risk assessments, but tailored specifically to the unique needs of the educational environment. Colleges and universities around the world should be actively encouraged by their governing boards and counsels to perform regular fraud risk assessments and vigorously implement and enforce compliance with targeted internal controls, such as proper segregation of duties and surprise audits. Of course, as with all organizations, universities can prevent fraud by segregating a task of requesting a financial transaction from those of approving it, processing the payment, reconciling the transaction to the appropriate accounts and safeguarding the involved asset(s). Surprise audits should be just that: unannounced supervisory reviews. This creates not just an atmosphere of collegiality and support but one in which the perceived opportunity to commit fraud is lowered.

As I’ve indicated again and again in the pages of this blog, the most powerful fraud prevention measure any organization can take is the education of its staff, top to bottom. Educating faculty, staff members and students about the university’s ethics (or anti-fraud) policies is important not only to prevent fraud but to preserve the institution’s reputation. It’s also important to develop ethics policies carefully and implement them in accordance with the particular culture and character of the institution.

Culturally, universities, like most nonprofit educational institutions, don’t like heavy-handed policies, or controls, because faculty members perceive them as impediments to their research and teaching activities. After going through an appropriate anti-fraud training program, every employee and faculty member (many higher-education institutions actually view faculty above the instructor level as quasi-independent contractors) should come to understand the nature and role of internal controls as well as the negative consequences associated with fraud.

University administrators, faculty and staff members can be motivated to prevent fraud on a basis of self-interest because its occurrence might affect their chances of promotions and salary increases and tarnish the external reputation of the university, which could then affect its financial situation and, hence, their individual prospects.

ACFE training tells us that organizational administrators who don’t get honest feedback and don’t hear and address fraud tips quickly can get in trouble politically, legally and strategically. All universities should implement user-friendly reporting mechanisms that allow anyone to anonymously report fraud and irregular activities plus deliver healthy feedback on leadership’s strengths and weaknesses. This will keep direct lines of communication open among all employees and senior university administrators. These tools will not only strengthen the fight against fraud but also advance the university’s strategic mission and refine senior administrators’ leadership styles. You can’t manage something you can’t see. Such tried and true mechanisms as independent internal audit departments and/or involved audit committees, should provide effective oversight of reporting mechanisms.

Still, many universities still resist pressure from their external stakeholders to implement hotlines because of concern they might create climates of mistrust among faculty members. Faculty members’ tendency to resist any effort to have their work examined and questioned may explain this resistance. Necessary cultural changes take some time, but educational institutions can achieve them with anti-fraud training and a substantial dose of ethical leadership and tone at the top.

From a legal perspective, colleges and universities, like any other nonprofit organization, must proactively demonstrate due diligence by adopting measures to prevent fraud and damage to their individual reputations. They’re also financially and ethically indebted to governments and donors to educate tomorrow’s leaders by demonstrating their ability to ensure that their internal policies and practices are sound.

Senior university administrators also must be able to show that they investigate all credible allegations of fraud. In addition, independent, professional and confidential fraud investigations conducted by you, the CFE, allow a victim university and its senior administrators to:

— determine the exact sources of losses and hopefully identify the perpetrator(s);
— potentially recover some or all of financial damages;
— collect evidence for potential criminal or civil lawsuits;
— avoid possible discrimination charges from terminated employees;
— identify internal control weaknesses and address them;
— reduce future losses and meet budget targets;
— comply with legal requirements such as senior administrators’ fiduciary duties of loyalty and reasonable care;
— reduce imputed university liability which may result from employee misconduct;

As CFE’s we should encourage client universities to adequately train and sensitize administrators, faculty and staff members about their ethics policies and the general problems related to occupational fraud in general. Administrators should also consider implementation of anonymous reporting programs and feedback processes among all stakeholders and among the senior administration. They should perform regular fraud risk assessments and implement targeted internal controls, such as proper segregation of duties and conflict-of-interest disclosures. Senior administrators should lead by example and adopt irreproachable behaviors at all times (tone at the top). Finally, faculty members’ job incentives should be aligned with the university’s mission and goals to avoid dysfunctional and illegal practices. All easier said than done, but, as a profession, let’s encourage them to do it when we have the chance!

Regulators & Silos

I was reading last week on LinkedIn about a large, highly regulated, financial institution that was defrauded over a long period of time by two different companies, both of which where its suppliers. To add insult to injury, subsequent investigation by a CFE revealed that the two vendors were subsidiaries of a third, which proved also to be a supplier of the victim concern; all three cooperated in the fraud and our victim was completely unaware prior to the investigation of any relationship between them; the kind of ignorance that can draw intense regulatory attention.

This is not as uncommon an occurrence as many might think but it is illustrative of the fact that today’s companies are increasingly forced to expend resources simply trying to understand and manage the complex web of relationships that exist between them and the organizations and people with which they deal; that is, if they want to avoid falling victim to frauds running the whole gamut from the simple to the complex. Such efforts involve gaining perspective on individual vendors and customers but extend far beyond that to include sorting through and classifying corporate hierarchies and complex business-to-business relationships involving partners, suppliers, distributors, resellers, contacts, regulators and employees.

These complex, sometimes overlapping, relationships are only exacerbated by dynamic geographic and cross-channel coordination requirements, and multiple products and customer accounts (our victim financial organization operates in three countries and has over 4,000 employees and hundreds of vendors). No fraud prevention program can be immune in the face of these challenges.

Financial companies that want to securely deliver the best experience to their stakeholders within intensified regulatory constraints need to provide themselves with a complete picture of all the critical parties in their relationships at the various points of service in the on-going process of company operations. The ability to do this requires that organizations have a better understanding of the complicated hierarchies and relationships that exist between them and their stakeholders. You cannot manage what you cannot see and you certainly cannot adequately protect it against fraud, waste and abuse.

The active study of organizational hierarchies and relationships (and their related fraud vulnerabilities) is a way of developing an integrated view of the relationship of risk among cooperating entities such as our CFE client companies between their affiliates, customers and partners, across multiple channels, geographies or applications. The identification of organizational relationships can help our client companies clearly and consistently understand how each of their affiliates, business divisions and contacts within a single multi-national enterprise fit within a broader, multidimensional context. Advanced organizational management approaches can help organizations track when key people change jobs within and between their related affiliates, vendors and companies. Advanced systems can also identify these individuals’ replacements feeding a database of who is where, vital to shifting patterns of enterprise risk.

Our client financial companies that take the time to identify and document their organizational relationships and place stakeholders into a wider hierarchical context realize a broad range of fraud, waste and abuse prevention related benefits, including:

• Enhanced ability to document regulatory compliance;
• More secure financial customer experiences, leading to enhanced reputation, increased loyalty and top-line growth;
• More confident financial reporting and more accurate revenue tracking;
• Reduction of over-all enterprise fraud risk;
• More accurate vetting of potential vendors and suppliers;
• More secure sales territory and partner program management;
• Improved security program compliance management;
• More accurate and effective fraud risk evaluation and mitigation.

The ability to place stakeholders within hierarchical context is invaluable to helping companies optimize business processes, enhance customer relationships and achieve enterprise-wide objectives like fraud prevention and mitigation. Organizations armed with the understanding provided by documented relationship contexts can improve revenues, decrease costs, meet compliance requirements, mitigate risk while realizing many other benefits.

As with our victimized financial enterprise, a company without relational data regarding vendors and other stakeholders can be unknowingly dealing with multiple suppliers who are, in fact, subsidiaries of the same enterprise, causing the company to not only inadvertently misrepresent its vendor base but, even more importantly, increase its vulnerability to fraud. Understanding the true relational context of an individual supplier may allow a company to identify areas of that vendor’s organization that represents enhanced internal control weakness or fraud risk. Conversely, an organization may fail to treat certain weakly controlled stakeholders strategically because the organization is unaware of just how much business it is doing with that stakeholder and its related subsidiaries and divisions.

Risk management has always been a core competency for organizations in general and for financial institutions in particular. However, integrated enterprise risk management (ERM) practices and corporate governance disciplines are now a regulatory imperative. Any institution that views corporate governance as merely a compliance exercise is missing the mark. Regulatory compliance is synonymous with the quality of the integrated ERM framework. Risk and control are virtually inseparable, like two sides of a coin, meaning that risks first must be identified and assessed, and then managed and mitigated by the implementation of a strong system of internal control. Accurate stake holder relational data is, therefore, critical to the effectiveness of the overall ERM process.

In today’s environment, the compliance onus rests with the regulated. In a regulatory environment where client enterprise ignorance of the situation in the client’s own overall enterprise is no longer a defense, responsibility for compliance now rests with the board and senior management to satisfy regulators that they have implemented a mature fraud prevention framework throughout the organization, effectively managing risk from the mailroom to the boardroom.

An integrated control framework with more integrated risk measures, both across risk types and economic and regulatory capital calculations, is warranted. Increased demands for self-attestation require elimination of fragmentation and silos in business and corporate governance, risk management, and compliance.

Compliance needs to be integrated into the organization’s ERM base fraud prevention framework, thereby making the management of regulatory risk a key part of effective overall compliance. Compliance needs to be seen as less of a function and more as an institutional state of mind, helping organizations to anticipate risk as well as to avoid it. Embedding compliance as a corporate discipline ensures that fraud prevention controls are entrenched in people’s roles and responsibilities more effectively than external regulations. The risk management function must not only address the compliance requirements of the organization but must also serve as an agent for improved decision making, loss reduction and competitive advantage within the marketplace.

Organizations can approach investments in corporate governance, relationship identification, risk management practices and regulatory compliance initiatives as one-off, isolated activities, or they can use these investments as an opportunity to strengthen and unify their risk culture, aligning best practices to protect and enhance stakeholder value. A silo-based approach to fraud prevention will not only be insufficient but will also result in compliance processes layered one upon the other, adding cost and duplication, and reducing the overall agility of our client’s business; in effect, increasing risk. This piecemeal reactive approach also leaves a gap between the processes designed to keep the organization in line with its regulatory obligations and the policies needed to protect and improve the franchise. Organizations are only as strong as their weakest components, like the links in a chain.

The ACFE tells us that people tend to identify with their positions, focusing more on what they do rather than on the purpose of it. This leads to narrowed vision on the job, resulting in a myopic sense of responsibility for the results produced when all positions interact. ln the event of risk management breakdowns or when results are below expectations, it is difficult for people to look beyond their silo. The enemy is out there syndrome, a byproduct of seeing only one’s own position, results in people quickly blaming someone or something outside themselves, including regulators, when negative events like long running frauds are revealed and retreating within the perceived safety of their fortress silo. This learning disability makes it almost impossible to detect the leverage that can be used on issues like fraud prevention and response that straddle the boundary between ‘us’ and ‘them’.

However, it is particularly disconcerting that the weakest numbers by industry sector, including financial services, occur in the ACFE studies measuring organization wide accountability and people’s understanding of their accountability. My personal feeling is that much of the reason for this low score is the perpetuation of organizational silos resulting from management’s failure to adequately identify and document all of its stakeholders’ cross-organizational relationships.

The Conflicted Board

Our last post about cyberfraud and business continuity elicited a comment about the vital role of corporate governance from an old colleague of mine now retired and living in Seattle.  But the wider question our commenter had was, ‘What are we as CFEs to make of a company whose Board willfully withholds for months information about a cyberfraud which negatively impacts it customers and the public? From the ethical point of view, does this render the Board somehow complicit in the public harm done?’

Governance of shareholder-controlled corporations refers to the oversight, monitoring, and controlling of a company’s activities and personnel to ensure support of the shareholders’ interests, in accordance with laws and the expectations of stakeholders. Governance has been more formally defined by the Organization for Economic Cooperation and Development (OECD) as a set of relationships between a company’s management, its Board, its shareholders, and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set (including about ethical continuity), and the means of attaining those objectives and monitoring performance. Good corporate governance should provide proper incentives for the Board and management to pursue objectives that are in the interests of the company and its shareholders and should facilitate effective monitoring.

The role and mandate of the Board of Directors is of paramount importance in the governance framework. Typically, the directors are elected by the shareholders at their annual meeting, which is held to receive the company’s audited annual financial statements and the audit report thereon, as well as the comments of the chairman of the Board, the senior company officers, and the company auditor.

A Board of Directors often divides itself into subcommittees that concentrate more deeply in specific areas than time would allow the whole Board to pursue. These subcommittees are charged with certain actions and/or reviews on behalf of the whole Board, with the proviso that the whole Board must be briefed on major matters and must vote on major decisions. Usually, at least three subcommittees are created to review matters related to (1) governance, (2) compensation, and (3) audit, and to present their recommendations to the full Board. The Governance Committee deals with codes of conduct and company policy, as well as the allocation of duties among the subcommittees of the Board. The Compensation Committee reviews the performance of senior officers, and makes recommendations on the nature and size of salaries, bonuses, and related remuneration plans. Most important to fraud examiners and assurance professionals, the Audit Committee reviews internal controls and systems that generate financial reports prepared by management; the appropriateness of those financial reports; the effectiveness of the company’s internal and external auditors; its whistle-blowing systems, and their findings; and recommends the re-election or not of the company’s external auditors.

The Board must approve the selection of a Chief Executive Officer (CEO), and many Boards are now approving the appointment of the Chief Financial Officer (CFO) as well because of the important of that position. Generally, the CEO appoints other senior executives, and they, in turn, appoint the executives who report to them. Members of these committees are selected for their expertise, interest, and character, with the expectation that the independent judgment of each director will be exercised in the best interest of the company. For example, the ACFE tells us, members of the Audit Committee must be financially literate, and have sufficient expertise to understand audit and financial matters. They must be of independent mind (i.e., not be part of management or be relying upon management for a significant portion of their annual income), and must be prepared to exercise that independence by voting for the interest of all shareholders, not just those of management or of specific limited shareholder groups.

Several behavioral expectations extend to all directors, i.e., to act in the best interest of the company (shareholders & stakeholders), to demonstrate loyalty by exercising independent judgment, acting in good faith, obedient to the interests of all and to demonstrate due care, diligence, and skill.

All directors are expected to demonstrate certain fiduciary duties. Shareholders are relying on directors to serve shareholders’ interests, not the directors’ own interests, nor those of management or a third party. This means that directors must exercise their own independent judgment in the best interests of the shareholders. The directors must do so in good faith (with true purpose, not deceit) on all occasions. They must exercise appropriate skill, diligence, and an expected level of care in all their actions.

Obviously, there will be times when directors will be able to make significant sums of money by misusing the trust with which they have been bestowed and at the expense of the other stakeholders of the company. At these times a director’s interests may conflict with those of the others. Therefore, care must be taken to ensure that such conflicts are disclosed, and that they are managed so that no harm comes to the other shareholders. For example, if a director has an interest in some property or in a company that is being purchased, s/he should disclose this to the other directors and refrain from voting on the acquisition. These actions should alert other directors to the potential self-dealing of the conflicted director, and thereby avoid the non-conflicted directors from being misled into thinking that the conflicted director was acting only with the corporation’s interests in mind.

From time to time, directors may be sued’ by shareholders or third parties who believe that the directors have failed to live up to appropriate expectations. However, courts will not second-guess reasonable decisions by non-conflicted directors that have been taken prudently and on a reasonably informed basis. This is known as the business judgment ru1e and it protects directors charged with breach of their duty of care if they have acted honestly and reasonably. Even if no breach of legal rights has occurred, shareholders may charge that their interests have been ‘oppressed’ (i.e., prejudiced unfairly, or unfairly disregarded) by a corporation or a director’s actions, and courts may grant what is referred to as an oppression remedy of financial compensation or other sanctions against the corporation or the director personally. If, however, the director has not been self-dealing or misappropriating the company’s opportunities, s/he will likely be protected from personal liability by the business judgment rule.

Some shareholders or third parties have chosen to sue directors ‘personally in tort’ for their conduct as directors, even when they have acted in good faith and within the scope of their duties, and when they believed they were acting in the best interests of the corporations they serve.  Recently, courts have held that directors cannot escape such personal liability by simply claiming that they did the action when performing their corporate responsibilities. Consequently, directors or officers must take care when making all decisions that they meet normal standards of behavior.

Consequently, when management and the Board of a company who has been the victim of a cyber-attack decides to withhold information about the attack (sometimes for weeks or months), fundamental questions about compliance with fiduciary standards and ethical duty toward other stakeholders and the public can quickly emerge.   The impact of recent corporate cyber-attack scandals on the public has the potential to change future governance expectations dramatically. Recognition that some of these situations appear to have resulted from management inattention or neglect (the failure to timely patch known software vulnerabilities, for example) has focused attention on just how well a corporation can expect to remediate its public face and ensure ongoing business continuity following such revelations to the public.

My colleague points out that so damaging were the apparently self-protective actions taken by the Boards of some of these victim companies in the wake of several recent attacks to protect their share price, (thereby shielding the interests of existing executives, directors, and investors in the short term) that the credibility of their entire corporate governance and accountability processes has been jeopardized, thus endangering, in some cases, even their ability to continue as viable going concerns.

In summary, in the United States, the Board of Directors sits at the apex of a company’s governing structure. A typical Board’s duties include reviewing the company’s overall business strategy, selecting and compensating the company’s senior executives; evaluating the company’s outside auditor, overseeing the company’s financial statements; and monitoring overall company performance. According to the Business Roundtable, the Board’s ‘paramount duty’ is to safeguard the interests of the company’s shareholders.  It’s fair to ask if a Board that chooses not to reveal to its stakeholders or to the general investor public a potentially devastating cyber-fraud for many months can be said to have meet either the letter or the spirit of its paramount duty.

Governance and Fraud Detection

Originally, the business owner had the most say in decisions regarding the enterprise. Then, corporate structures were put in place to facilitate decision making, as ownership was spread over millions of shareholders. Boards of directors took over many responsibilities. But with time, the chief executive officer (CEO) ended up having a large say in the composition of the board and, in many instances, ruled and controlled the company and its strategy. The only option for shareholders appeared to be to sell their shares if they were not happy with the performance of a specific organization. Many anti-fraud professionals think that this situation contributed significantly to business demises such as that of Enron and to the horrors consequent to the mortgage meltdown and accompanying fiscal crisis.

Proposals were made to re-equilibrate the power structure by giving more power and responsibilities to the board and to specific committees, such as the audit committee, to better deal with internal control and fair financial reporting or the remuneration committee to better deal with the basis for the type and the level of remuneration of the CEO. New legislation was put into place, such as the US Sarbanes-Oxley Act and Basel II. Compliance with these pieces of legislation consumed a lot of attention, energy and cost.

Enterprises exist to deliver value to their stakeholders. This is accomplished by handling risk advantageously and using resources responsibly. Speedy direction setting and quick reaction to change are essential in such a situation so decision making must be shared among many. Therefore, governance comes into play. Successful enterprises implement an over-arching system of governance that facilitates the achievement of their desired outcomes, both at the enterprise level and at each level within the enterprise; this is especially true with regard to the problem of fraud detection.  In this context, a holistic definition of enterprise governance is in order: Governance is the framework, principles, structure, processes and practices to set direction and monitor compliance and performance aligned with the overall purpose and objectives of an enterprise.

This definition is initially implemented by the answers to and actions on the following governance related questions:

Who is accountable and responsible for enterprise governance? Stakeholders, owners, governing bodies and management are responsible and accountable for governance.

What do they do, and how and where do they do it? They engage in activities (set direction, monitor compliance and performance) in relationship with others and use enablers (frameworks, principles, structures, processes, practices) within the governance view appropriate to them (governance of the enterprise; of an organizational entity within the enterprise such as a business unit, division or function; and of a strategic asset within the enterprise or within an organizational entity).

Why do they do it? They institute governance to create value for their enterprise, determine its risk appetite, optimize its resources and use them responsibly.

In summary, accountability and stewardship are delegated to a governance body by the owner/stakeholder, expecting it to assume accountability for the activities necessary to meet expectations. In alignment with the overall direction of the enterprise, management executes the appropriate activities within the context of a control framework, balancing performance and compliance in achieving the governance objectives of value creation, risk management and resource optimization.

Fraud detection (within the context of a fully defined fraud prevention program) is a vital business process of the over-hanging governance function and can be implemented by numerous generally accepted procedures.  But a few examples …

One way to increase the likelihood of the detection by the governance function of fraud abuses is the conduct of periodic external and internal audits, as well as the implementation of special network security audits. Auditors should regularly test system controls and periodically “browse” data files looking for suspicious activities. However, care must be exercised to make sure employees’ privacy rights are not violated. Informing employees that auditors will conduct a random surveillance not only helps resolve the privacy issue, but also has a significant deterrent effect on computer assisted fraud exploits.

Employees witnessing fraudulent behavior are often torn between two conflicting feelings. They feel an obligation to protect company assets and turn in fraud perpetrators, yet they are uncomfortable in a whistleblower role and find it easier to remain silent. This reluctance is even stronger if they are aware of public cases of whistleblowers who have been ostracized or persecuted by their coworkers or superiors, or have had their careers damaged. An effective way to resolve this conflict is to provide employees with hotlines so they can anonymously report fraud. The downside of hotlines is that many of the calls are not worthy of investigation. Some calls come from those seeking revenge, others are vague reports of wrongdoing, and others simply have no merit. A potential problem with a hotline is that those who operate the hotline may report to people who are involved in a management fraud. This threat can be overcome by using a fraud hotline set up by a trade organization or commercial company. Reports of management fraud can be passed from this company directly to the board of directors.

Many private and public organizations use outside computer consultants or in-house teams to test and evaluate their security procedures and computer systems through the performance of system penetration testing.  The consultants are paid to try everything possible to compromise an enterprise’s system(s). To get into offices so they can look for passwords or get on computers, they masquerade as janitors, temporary workers, or confused delivery personnel. They also employ software based hacker tools (readily available on the Internet) and social engineering techniques.  Using such methods, some outside consultants claim that they can penetrate 90% or more of the companies they “attack” to a greater or lesser degree.

All financial transactions and activities should be recorded in a log. The log should indicate who accessed what data, when, and from which location. These logs should be reviewed frequently to monitor system activity and trace any problems to their source. There are numerous risk analysis and management software packages that can review computer systems and networks and the financial transactions they contain. These packages evaluate security measures already in place and test for weaknesses and vulnerabilities. A series of reports are then generated to explain any weaknesses found and suggest improvements. Cost parameters can be entered so that a company can balance acceptable levels of vulnerability and cost effectiveness. There are also intrusion-detection programs and software utilities that can detect illegal entry into systems along with software that monitors system activity and helps companies recover from fraud and malicious actions.

People who commit fraud tend to follow certain patterns and leave tell-tale clues, often things that do not make sense. Software is readily available to search for these fraud symptoms. For example, a health insurance company could use fraud detection software to look at how often procedures are performed, whether a diagnosis and the procedures performed fit a patient’s profile, how long a procedure takes, and how far patients live from the doctor’s office.

Neural networks (programs that mimic brain activity and can learn new concepts) are quite accurate in identifying suspected fraud. For example, Visa and MasterCard operations employ neural network software to track hundreds of millions of separate account transactions daily. Neural networks spot the illegal use of a credit card and notify the owner within a few hours of its theft. The software can also spot trends before bank investigators do.

Each enterprise needs to determine its appropriate overall governance system and the fraud detection approaches it decides to implement in support of that system. To help in that determination, mapping governance frameworks, principles, structures, processes and practices, currently in use, is beneficial. CFE’s and forensic accountants are uniquely qualified to assist in this process given their in-depth knowledge of all types of fraud scenarios and the tailoring of the anti-fraud controls most appropriate for the control of each within a specific company environment.

Structure & Scope

T.J. Jones presented himself as a turnaround specialist to the Chairman of the Board of Central State Corporation, a medium sized, public company, a mid-western manufacturer of computer equipment, who hired him to take over a large, but under-performing division of the company.  Jones immediately set out lofty goals for sales and profits and very quickly replaced all the existing senior staff of the division with new hires loyal to himself. To meet his inflated goals, two of Jones’s managers, in addition to legitimate equipment sales, shipped bricks to distributors and recorded some as sales of equipment to retail distributors and some as inventory out on consignment. No real products left the plant for these “special sales.” The theory was that actual sales would inevitably grow, and the bricks could be replaced later with real products. In the meantime, the unwitting distributors thought they were holding consignment inventory in the unopened cartons.

The result was that overstated sales and accounts receivable quickly caused overstated net income, retained earnings, current assets, working capital, and total assets. Prior to the manipulation, annual sales of the division were $135 million. During the two falsification years of the fraud, sales were $185 million and $362 million. Net income went up from a loss of $20 million to $23 million (income), then to $31 million (income); and the gross margin percent went from 6 percent to 28 percent. The revenue and profit figures outpaced the performance of Central State’s industry category. The accounts receivable collection period grew to 94 days, while it was 70 days elsewhere in the industry.

All the paperwork was in order because the two hand-picked managers had falsified the sales and consignment invoices, even though they did not have customer purchase orders for all the false sales. Shipping papers were in order, and several co-operating shipping employees knew that not every box shipped contained disk drives. Company accounting and control procedures required customer purchase orders or contracts evidencing real orders. A sales invoice was supposed to indicate the products and their prices, and shipping documents were supposed to indicate actual shipment. Sales were always charged to a customer’s account receivable.  During the actual operation of the fraud there were no glaring control omissions that would have pointed to financial fraud. Alert auditors might have noticed the high tension created by concentration on meeting profit goals. Normal selection of sales transactions with vouching to customer orders and shipping documents might have turned up a missing customer order. Otherwise, the paperwork would have seemed to be in order. The problem lay in Jones’ and his managers’ power to override controls and to instruct some shipping staff to send dummy boxes.  Confirmations of distributors’ accounts receivable may have elicited exception responses. The problem was to have a large enough confirmation sample to pick up some of these distributors or to be skeptical enough to send a special sample of confirmations to distributors who took the “sales” near the end of the accounting period. Observation of inventory could have included some routine inspection of goods not on the company’s premises.

The overstatements were not detected. The auditor’s annual confirmation sample was typically small and did not contain any of the false shipments. Tests of detail transactions did not turn up any missing customer orders. The inventory out on consignment was audited by obtaining a written confirmation from the holders, who apparently over the entire period of the fraud had not opened even one of the affected boxes. The remarkable financial performance was attributed to good management.

The fraud was revealed by one of Jones’ subordinate managers who was arrested on an unrelated drug charge and volunteered as a cooperating witness in exchange for the dropping of the drug charge.

This hypothetical case is a good example of the initial situation confronting management when a fraud affecting the financial statements comes to light, often with little or no warning. Everyone involved with company management will have a strong intuitive sense that an investigation is necessary; but the fact is that the company has now lost faith in the validity of its own public disclosures of financial performance.

That will need to be fixed. And it is not enough to simply alert markets that previously issued financial results are wrong; outsiders will want to know what the correct numbers should have been. The only way to find out is to dig into the numbers and distinguish the falsified results from the real ones. Beyond the need to set the numbers straight, the company will need to identify those complicit in the fraud and deal with them. This is not only a quest for justice but the need to restore credibility, and the company will be unable to do so until outsiders are satisfied that the wrongdoing executives and staff have been identified and removed.  Thus, the company needs an audit report on its financial statements. The need for a new audit report arises from the likelihood that, once a company’s financial statements have been found to be unreliable, the company’s external auditor will want to pull its existing, inaccurate,  report.

As a practical matter, pulling its report involves the external auditor’s recommendation that the company issue a press release that previously issued financial statements are not to be relied upon. Once the company issues such a press release, it will be out of compliance with any number of SEC regulations. It will no longer satisfy the threshold prerequisites for trading on the company’s securities exchange. It will be viewed by many, and certainly the plaintiff class action bar, as coming close to having admitted wrongdoing. And everyone on the outside, not to mention its own board of directors, will want answers fast. A critical step in the restoration of important business relationships and a return to compliance with regulatory requirements is the new auditor’s report. And, where fraudulent financial reporting has been discovered, an in-depth and comprehensive investigation is often the only way to get one.

A critical issue at the outset of a financial fraud investigation is its structure and scope. A key attribute for which the external auditor, as well as the SEC, will be on the lookout is that the investigation is overseen by the audit committee. In public companies, it is the audit committee that has explicit legal responsibility for oversight of financial reporting, and accounting fraud falls squarely within the orbit of financial reporting.  In addition, the audit committee, as a matter of statutory design, is structured to be independent and possessed of a level of financial sophistication that makes it the most viable subset of the board of directors to oversee the investigative efforts in this case. It’s also the audit committee that has the statutory power to engage and pay outside advisers even without the consent of management, a statutory power that can be vital if management, or part of management, as in our hypothetical case above, is a participant in the fraud.

The audit committee’s role is to oversee the investigation, not actually conduct it. For that it needs to look to outside professionals, and there are two types. The one is the outside counsel to the audit committee. If the audit committee has not already engaged outside counsel, it needs to do so. It’s audit committee counsel who will conduct the interviews, comb through the financial records, and present factual findings for audit committee consideration. Individual audit committee members may choose to sit in on interviews, and that is their choice. But it’s audit committee counsel who will conduct the investigation. The other group of professionals is the forensic accountants and/or CFEs.  Audit committee counsel, while knowledgeable of financial reporting obligations and investigative techniques, will probably not possess a sufficiently detailed knowledge of accounting systems, generally accepted accounting principles (GAAP), or computerized ledgers. For that, audit committee counsel is well advised look for help to the category of accountants and fraud examiners specifically trained in digging into financial records for evidence of fraud.

What exactly is the audit committee looking for in such an investigation? There are primarily two things. The first, obviously enough, is what the actual numbers should have been. Often fraudulent entries involve judgment calls where the operative question is not whether the number matches the underlying financial records but whether the judgment behind the number was exercised in good faith.  The operative question for the investigators is whether the executive exercised his judgment in good faith to make the best estimate allowed by reasonably available information. Sometimes it’s not so easy to tell.

Beyond the correct numbers, the second thing for which the investigators are looking is executive complicity. In other words: who did it? Again, the good faith of those potentially involved comes into play. The investigators are not seeking simply whether executives reported financial results that turned out to be wrong. The issue rather is whether the executives tried to get them right. If they did and made an honest mistake or estimated incorrectly, that does not sound like fraud and may not even be a violation of GAAP to begin with. The main point here is that, when it comes to executive complicity, the investigators are ordinarily looking for evidence of wrongful intent (scienter). In other words, they are looking for an intentional misapplication of GAAP or an approach to GAAP that is so reckless as to constitute the equivalent of an intentional misapplication.

The scope of the investigation, then, should not pose too difficult an issue at the outset.  Initially, the scope will be largely defined by the potential improprieties that have been uncovered. The tricky question becomes: how far should the investigators go beyond the suspicious entries? The judgment calls here are formidable. One of the key issues involves the expectations of the external auditor and, beyond that, the SEC. If the scope is not sufficiently broad, the investigation may not be satisfactory to either one. Indeed, an insufficient scope can place the external auditor in a particularly awkward spot insofar as the SEC may subsequently fault not only the audit committee for inadequate scope but the external auditor’s acceptance of the audit committee’s investigative report.
An additional complicating factor involves the way fraud starts and grows. A critical issue to consider is that, overtime, as the Central State example illustrates, the manipulations will often get increasingly aggressive as the perpetrators spread the fraud throughout many line items so that no single account stands out as unusual but a substantial number are affected. For example, to prevent the distortion of accounts receivable from getting too large, Jones and his accomplices spread the fraud into inventory, then asset capitalization, then net income. The spread of the fraud is analogous to pouring a glass of water on a tabletop. It can spread everywhere without getting too deep in any one place.

So, once fraudulent financial reporting has been identified, even in just a few entries, the investigators will want to consider the possibility that it’s a symptom of a broader problem. If the investigators have been lucky enough to nip it in the bud, that may be the end of it.  Unfortunately, if the fraud has gotten big enough to be detected in the first place, such a limited size cannot be assumed. Even where the fraud ostensibly starts out small the need for a broader scope has got to be considered.

The scope of the investigation, therefore, can start out with its parameters guided by the suspicious entries revealed at the outset. In most cases, though, it will need to broaden to ensure that additional areas are not affected as well. Throughout the investigation, moreover, the scope will have to remain flexible. The investigators will have to stay on the lookout for additional clues, and will have to follow where they lead. Faced with an ostensibly ever-widening scope, initial audit committee frustration is both to be expected and understandable. But there is just no practical alternative.

For Appearance Sake

By Rumbi Petrozzello, CPA/CFF, CFE
2017 Vice-President – Central Virginia Chapter ACFE

Last Thursday, the 15th of June 2017, the New York State Senate Committee on Ethics and Internal Governance met. The previous sentence reads like a big yawn with which no one, beyond perhaps the members of the committee itself, would be concerned. However, this meeting was big news. The room was packed with members of the media and every member of the committee was in attendance. Why? Because this was the first meeting the committee had empaneled since 2009, as confirmed by the committee’s published archive of events. It turns out that it was indeed a big deal that all committee members were in attendance because, for eight years straight, none of the committee members had attended a single meeting.

If you are thinking that the ethics committee did not meet for eight years because there were no ethical issues to discuss and our state’s legislative leadership practiced only ethical and upright behavior, you would be sorely mistaken. John Sampson, the State Senator who chaired the committee at that last meeting in 2009 was found guilty, of obstruction of justice and of lying to federal agents in 2015 and sentenced to jail time in January 2017. Evidently, taking their cues from the tone at the top evidenced by the leadership of their ethics committee, during the same eight-year meeting hiatus, seven other state senators were convicted on charges that included mail fraud, looting a nonprofit and bribery.

So, you might ask, what happened at the meeting last week? The committee had come together to discuss stipends, that are supposed to go to committee chairs, that were apparently also being paid to committee vice-chairs (and, in one case, to a deputy vice-chair, whatever that is). There was a motion proposed to stop making these payments to anyone but the committee chair. It seems that just coming together was more than enough work for the committee and, therefore, they tabled the motion, a motion that would not even have been binding, until its next meeting. It should be noted that two of the senators receiving this chair stipend, as vice-chairs, serve on the ethics committee and both voted to postpone voting on the motion. It would be laughable if it were a laughing matter.

Think about where you work and about all the clients with whom we work, as fraud examiners and forensic accountants. We work with our clients and with those who employ us to suggest comprehensive policies that cover good business practices and ethical behaviors and actions. Reading about the shenanigans of the State Senate Committee on Ethics recalled several thoughts:

The assumption that personnel will automatically be motivated to behave as corporate owners want is no longer valid. People are motivated more by self-interest than in the past and are likely to come from backgrounds that emphasize different priorities of duty. As a result, there is greater need than ever for clear guidance and for identifying and effectively managing threats to good governance and accountability.

Even when different employee backgrounds are not an issue, personnel can misunderstand the organization’s objectives and their own role and fiduciary duty. For example, many directors and employees at Enron evidently believed that the company’s objectives were best served by actions that brought short term profit:

—through ethical dishonesty, manipulation of energy markets or sham displays of trading floors;
—through book keeping that was illusory;
—through actions that benefited themselves at the expense of other stakeholders.

Frequently, employees are tempted to cut ethical corners, and they have done so because they believed that their top management wanted them to; they were ordered to do so; or they were encouraged to do so by misguided or manipulative incentive programs. These actions occurred although the board of directors would have preferred (sometimes with hindsight) that they had not. Personnel simply misunderstood what was expected by the board because guidance was unclear or they were led astray and did not understand that they were to report the problem for appropriate corrective action, or to whom or how.

Among our clients, lack of proper guidance or reporting mechanisms may have been the result of directors and others not understanding their duties as fiduciaries. Directors owe shareholders and regulators several duties, including obedience, loyalty, and due care. Recognition of the increasing complexity, volatility and risk inherent in modern corporate interests and operations, particularly as their scope expands to diverse groups and cultures has led to the requirement for risk identification, assessment and management systems.

  • If our client businesses want to do an excellent job at implementing effective ethics programs, orientation of new employees should always involve a review of the code of ethical practice by the staff tasked with compliance and with enforcing policies. How many entities are actively practicing what they preach during such sessions? The values that a company’s directors wish to instill to motivate the beliefs and actions of its personnel need to be conveyed to provide the required guidance. Usually, such guidance takes the form of a code of conduct that states the values selected, the principles that flow from those values, and any rules that are to be followed to ensure that appropriate values are respected.
  • After orientation, what steps are companies taking to maintain their ethics programs on an on-going basis? Principles are more useful to employees than just rules because principles facilitate interpretation when the precise circumstances encountered do not exactly fit the rules prescribed. A blend of principles and rules is often optimal in maintaining of a code of conduct in the long term.
  • Is leadership periodically coming together to talk about where their firm stands when it comes to ethics and compliance? A code on its own may be nothing more than ‘ethical art’ that hangs on the wall but is rarely studied or followed. Experience has revealed that, to be effective, a code must be reinforced by a comprehensive ethical culture.
  • Is anyone reviewing how whistleblowing claims are being dealt with? Does the company even have a whistleblower program? If so, does the staff even know about it and how it works? Whistle-blowers are part of a needed monitoring, risk management and remediation system.
  • Is leadership setting a positive tone at the top and displaying the behaviors that it is demanding from employees? The ethical behavior expected must be referred to in speeches and newsletters by top management as often as they refer to their health and safety programs, or to their antipollution program or else it will be viewed as less important by employees. If personnel never or rarely hear about ethical expectations, they will perceive them as not a serious priority.

Once, I worked at a company where senior management smoked in the office; behavior that is illegal and was, on paper, not allowed. When staff members complained to human resources, no corrective action was taken. Frustrated, some staff members called the city hotline to file a report. Following visits from the city, human resources put up no smoking signs and then notices encouraging employees to keep reports of inappropriate staff smoking internal. By only paying lip service to policy, this company’s management seemed populated by future candidates for the State’s Senate Ethics Committee. But my former employer doesn’t stand alone as evidenced by frauds at Wells Fargo and at others. A company can pull out screeds of rules and regulations, but what matters most is what the staff knows and what the leadership does.

In the case of the New York State Senate Committee on Ethics and Internal Governance, what it did was delay a vote on the issues before it until the next meeting. And when will the next meeting be? After taking eight years to set up its last meeting, the committee was in no hurry to set a date for the next. They adjourned without scheduling the next one. They did, however, take a moment to congratulate themselves on attending this meeting. You can’t forget the important stuff.

SOX, Fraud and the Audit Committee

sarbans-oxleyA practicing CFE and subscriber to this blog contacted us to say that he’s been asked to make a presentation to the audit committee of a small public company client for whom he recently completed an examination of a financial fraud.  The audit committee, in light of the control vulnerabilities uncovered by our CFE’s report, wants a briefing on its responsibilities under SOX (the Sarbanes-Oxley Act) so it, in turn, can assure that management’s future performance deters any fraud recurrence.

Since its inception in 2002, SOX has had a material impact on the way boards of directors, management, and accountants of publicly held companies operate. It has also had a dramatic impact on the certified public accountants of publicly held companies and the audits of those companies. Since the enactment of Sarbanes Oxley, the Securities and Exchange Commission (SEC) has issued numerous SEC Releases that support and expand the SOX requirements. Many of the most important provisions of SOX and of the corresponding SEC Releases relate to fraud detection and prevention.

SOX gave audit committees more power and responsibility over a company’s auditors. The intent of the rules is to make the audit committee (rather than company management) the auditor’s “client.” Companies can be delisted from the stock exchanges if they fail to comply with the rules.

  • The auditor’s report is to be overseen by a company’s audit committee, not management;
  • Audit committees are responsible for hiring, compensating, and overseeing the registered public accounting firms they employ, and hiring independent counsel and any other advisors they determine necessary;
  • Each person on the audit committee must be a member of the board of directors and be otherwise independent of the company. SOX defines “independent” as not receiving any other compensation from the company and not being affiliated with the company or any of its subsidiaries;
  • One member of the audit committee must be a financial expert. A company without a financial expert must disclose that fact and explain its rationale. The SEC has defined a financial expert as someone with:

–An understanding of GAAP and financial statements;
–The ability to assess whether GAAP was used in estimates, accruals, and reserves;
–Experience with financial statements of a similar breadth and complexity of issues;
–An understanding of internal controls and financial reporting procedures;
–An understanding of audit committee functions;
–The New York Stock Exchange requires the chair of the audit committee to have accounting or financial management experience. It also requires a nominating committee and a compensation committee composed of independent directors;
–Companies provide appropriate funding to their audit committee;
–Audit committees pre-approve all audit and non-audit services provided by their auditor that are not specifically prohibited by SOX;
–Audit committees set up procedures to receive and deal with any complaints the company receives about accounting, internal control, auditing, and similar issues.

On the other hand, the biggest requirement for management of public companies that SOX mandates is more responsibility for financial reports filed with the SEC. SOX requires both the chief executive officer (CEO) and chief financial officer (CFO) of a company to prepare a statement to accompany the audit report that certifies their quarterly and annual financial statements and disclosures. There are six elements to the management certification:

  1. The financial statements have been reviewed by management;
  2. The statements do not contain an untrue statement of a material fact or omit a material fact that makes the statements misleading;
  3. The statements fairly present, in all material respects, the operations, financial condition, and cash flow of the issuer;
  4. Management is responsible for designing, installing, and evaluating disclosure controls and procedures, and reporting its conclusions with respect to its effectiveness;
  5. All material internal control weaknesses and fraud are disclosed to the auditor;
  6. All significant changes to internal controls after management’s evaluation have been disclosed and corrected.

These rules were implemented to assure investors that the information in a company’s quarterly and annual reports is accurate and contains all of the company information that the executives believe is important to a reasonable investor. If management willfully and knowingly violates this certification process, it can be punished with imprisonment of up to 20 years and a fine of up to $5,000,000. In addition, if financial reports must be restated due to material noncompliance with financial reporting requirements, a violation of securities laws, or securities fraud, company management can be required to repay bonuses and incentives or equity-based compensation it realized during the twelve months following the issuance or filing of the noncompliant document. It can also be required to repay any profits it realized from the sale of company securities during the same period. As a result of these certification requirements, it’s not surprising that many public company CEOs and CFOs have spent a great deal of time since 2002 conducting due diligence procedures on their financial statements before certifying them.

From a specifically fraud prevention perspective, SOX also sets out the following the following requirements of interest to our CFE reader’s audit committee and executive management:

  • Company officers and directors cannot take any action to fraudulently influence, coerce, manipulate, or mislead auditors to make the financial statements materially misleading;
  • Company executives and directors cannot receive loans that are unavailable to those outside the company. There is an exception for loans, such as a home mortgage or a credit card agreement, if they are on the same terms and conditions as those made to the general public and done in the ordinary course of business;
  • Company executives and directors cannot trade company stock during blackout periods when other employees are unable to do so. Profits from doing so can be recovered;
  • All insider stock trades involving executives and individuals who own 10 percent or more of the company must be reported electronically to the SEC within two days and posted to the company’s website;
  • All financial reports required by GAAP must contain all material correcting adjustments identified by the auditors;
  • All annual and quarterly financial reports must disclose all material off-balance sheet transactions and relationships with unconsolidated entities likely to have a material effect on the company’s financial condition;
  • Pro forma financial information must not contain any untrue statements or omit a material fact that would make it misleading, and it should be in conformance with company financial information prepared according to GAAP;
  • Companies must disclose, in plain English, material changes to their financial condition on a rapid and current basis.

Also of interest to our reader’s audit committee would be the criminal penalties.  Sarbanes-Oxley and the SEC rules implementing its requirements increased the maximum penalties for many white-collar crimes and created tougher penalties for people who destroy records, commit securities fraud, and fail to report fraud. CPA firms are required to preserve all audit or review work papers, including e-mail, for at least seven years after the audit is complete. Willfully failing to do so or intentionally destroying these records is a felony, with penalties of up to 10 years of incarceration. Sarbanes-Oxley also created a new felony, with penalties of up to 20 years of incarceration and a hefty fine, for destroying, altering, or fabricating documents to impede, obstruct, or influence any existing or contemplated federal investigation. The criminal penalty for securities fraud was increased to 25 years. The statute of limitations on securities fraud claims was extended from one to two years from the date the fraud is discovered, and from three to five years after the fraud took place. Sarbanes-Oxley increases the penalty for CEOs and CFOs who knowingly certify fraudulent financial statements or submit materially misleading statements to the SEC to a maximum of 10 years of imprisonment and a $1 million fine. CEOs and CFOs who willingly do so will face a maximum penalty of 20 years of imprisonment and a $5 million fine.