The Initially Immaterial Financial Fraud

At one point during our recent two-day seminar ‘Conducting Internal Investigations’ an attendee asked Gerry Zack, our speaker, why some types of frauds, but specifically financial frauds, can go on so long without detection. A very good question and one that Gerry eloquently answered.

First, consider the audit committee. Under modern systems of internal control and corporate governance, it’s the audit committee that’s supposed to be at the vanguard in the prevention and detection of financial fraud. What kinds of failures do we typically see at the audit committee level when financial fraud is given an opportunity to develop and grow undetected? According to Gerry, there is no single answer, but several audit committee inadequacies are candidates. One inadequacy potentially stems from the fact that the members of the audit committee are not always genuinely independent. To be sure, they’re required by the rules to attain some level of technical independence, but the subtleties of human interaction cannot always be effectively governed by rules. Even where technical independence exists, it may be that one or more members in substance, if not in form, have ties to the CEO or others that make any meaningful degree of independence awkward if not impossible.

Another inadequacy is that audit committee members are not always terribly knowledgeable, particularly in the ways that modern (often on-line, cloud based) financial reporting systems can be corrupted. Sometimes, companies that are most susceptible to the demands of analyst earnings expectations are new, entrepreneurial companies that have recently gone public and that have engaged in an epic struggle to get outside analysts just to notice them in the first place. Such a newly hatched public company may not have exceedingly sophisticated or experienced fiscal management, let alone the luxury of sophisticated and mature outside directors on its audit committee. Rather, the audit committee members may have been added to the board in the first place because of industry expertise, because they were friends or even relatives of management, or simply because they were available.

A third inadequacy is that audit committee members are not always clear on exactly what they’re supposed to do. Although modern audit committees seem to have a general understanding that their focus should be oversight of the financial reporting system, for many committee members that “oversight” can translate into listening to the outside auditor several times a year. A complicating problem is a trend in corporate governance involving the placement of additional responsibilities (enterprise risk management is a timely example) upon the shoulders of the audit committee even though those responsibilities may be only tangentially related, or not at all related, to the process of financial reporting.

Again, according to Gerry, some or all the previously mentioned audit committee inadequacies may be found in companies that have experienced financial fraud. Almost always there will be an additional one. That is that the audit committee, no matter how independent, sophisticated, or active, will have functioned largely in ignorance. It will not have had a clue as to what was happening within the organization. The reason is that a typical audit committee (and the problem here is much broader than newly public startups) will get most of its information from management and from the outside auditor. Rarely is management going to voluntarily reveal financial manipulations. And, relying primarily on the outside auditor for the discovery of fraud is chancy at best. Even the most sophisticated and attentive of audit committee members have had the misfortune of accounting irregularities that have unexpectedly surfaced on their watch. This unfortunate lack of access to candid information on the part of the audit committee directs attention to the second in the triumvirate of fraud preventers, the internal audit department.

It may be that the internal audit department has historically been one of the least understood, and most ineffectively used, of all vehicles to combat financial fraud. Theoretically, internal audit is perfectly positioned to nip in the bud an accounting irregularity problem. The internal auditors are trained in financial reporting and accounting. The internal auditors should have a vivid understanding as to how financial fraud begins and grows. Unlike the outside auditor, internal auditors work at the company full time. And, theoretically, the internal auditors should be able to plug themselves into the financial reporting environment and report directly to the audit committee the problems they have seen and heard. The reason these theoretical vehicles for the detection and prevention of financial fraud have not been effective is that, where massive financial frauds have surfaced, the internal audit department has often been somewhere between nonfunctional and nonexistent.. Whatever the explanation, (lack of independence, unfortunate reporting arrangements, under-staffing or under-funding) in many cases where massive financial fraud has surfaced, a viable internal audit function is often nowhere to be found.

That, of course, leaves the outside auditor, which, for most public companies, means some of the largest accounting firms in the world. Indeed, it is frequently the inclination of those learning of an accounting irregularity problem to point to a failure by the outside auditor as the principal explanation. Criticisms made against the accounting profession have included compromised independence, a transformation in the audit function away from data assurance, the use of immature and inexperienced audit staff for important audit functions, and the perceived use by the large accounting firms of audit as a loss leader rather than a viable professional engagement in itself. Each of these reasons is certainly worthy of consideration and inquiry, but the fundamental explanation for the failure of the outside auditor to detect financial fraud lies in the way that fraudulent financial reporting typically begins and grows. Most important is the fact that the fraud almost inevitably starts out very small, well beneath the radar screen of the materiality thresholds of a normal audit, and almost inevitably begins with issues of quarterly reporting. Quarterly reporting has historically been a subject of less intense audit scrutiny, for the auditor has been mainly concerned with financial performance for the entire year. The combined effect of the small size of an accounting irregularity at its origin and the fact that it begins with an allocation of financial results over quarters almost guarantees that, at least at the outset, the fraud will have a good chance of escaping outside auditor detection.

These two attributes of financial fraud at the outset are compounded by another problem that enables it to escape auditor detection. That problem is that, at root, massive financial fraud stems from a certain type of corporate environment. Thus, detection poses a challenge to the auditor. The typical audit may involve fieldwork at the company once a year. That once-a-year period may last for only a month or two. During the fieldwork, the individual accountants are typically sequestered in a conference room. In dealing with these accountants, moreover, employees are frequently on their guard. There exists, accordingly, limited opportunity for the outside auditor to get plugged into the all-important corporate environment and culture, which is where financial fraud has its origins.

As the fraud inevitably grows, of course, its materiality increases as does the number of individuals involved. Correspondingly, also increasing is the susceptibility of the fraud to outside auditor detection. However, at the point where the fraud approaches the thresholds at which outside auditor detection becomes a realistic possibility, deception of the auditor becomes one of the preoccupations of the perpetrators. False schedules, forged documents, manipulated accounting entries, fabrications and lies at all levels, each of these becomes a vehicle for perpetrating the fraud during the annual interlude of audit testing. Ultimately, the fraud almost inevitably becomes too large to continue to escape discovery, and auditor detection at some point is by no means unusual. The problem is that, by the time the fraud is sufficiently large, it has probably gone on for years. That is not to exonerate the audit profession, and commendable reforms have been put in place over the last decade. These include a greater emphasis on fraud, involvement of the outside auditor in quarterly data, the reduction of materiality thresholds, and a greater effort on the part of the profession to assess the corporate culture and environment. Nonetheless, compared to, say, the potential for early fraud detection possessed by the internal audit department, the outside auditor is at a noticeable disadvantage.

Having been missed for so long by so many, how does the fraud typically surface? There are several ways. Sometimes there’s a change in personnel, from either a corporate acquisition or a change in management, and the new hires stumble onto the problem. Sometimes the fraud, which quarter to quarter is mathematically incapable of staying the same, grows to the point where it can no longer be hidden from the outside auditor. Sometimes detection results when the conscience of one of the accounting department people gets the better of him or her. All along s/he wanted to tell somebody, and it gets to the point where s/he can’t stand it anymore and s/he does. Then you have a whistleblower. There are exceptions to all of this. But in almost any large financial fraud, as Gerry told us, one will see some or all these elements. We need only change the names of the companies and of the industry.

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