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In the popular imagination, management fraud and corruption seems to exist almost everywhere. The facts show that mercantile fraud has been a perpetual scourge in many societies. It is nevertheless instructive to analyze the cause of fraud as a basis for appropriate risk management. These include economic recession, employee disaffection, indifference to internal control, a possible erosion of ethics, inability of an obsolete system to accommodate new transaction types and volumes, and often a time lag while organizational rules catch up with new ways of committing offences. Initial failure to detect fraud also tends to be aggravated by failure to apply audit scepticism. Fraud and corruption are likely to gain even greater attention in the neat future, as existing functions of public service are “outsourced”.
In an 1866 issue of the law journal Temple Bar, a contemporary observer wrote: “Go where you will, in business parts, or meet who you like of business men, it is…the same story and the same lament. Dishonesty, untruth, and what may, in plain English, be termed mercantile swindling within the limits of the law, exist on all sides and on every quarter” (Hotten, 1993).
The public's feeling of being beleaguered by swindlers has not abated; it was recently reported that nearly two-thirds of UK voters were concerned with corruption in local government. They expressed fear that “opportunists were taking advantage of an entrepreneurial culture in which the pace of reforms had outstripped the development of safeguards” (Darch, 1994). Citing KPMG, Atkinson (1994) reported a new problem: it was asserted that the increasing trend towards contracting out public services to private firms could trigger an “explosion in fraud and corruption”. The firm worried that “backhanders and slush money” might flood public agencies as firms endeavor to cut themselves into lucrative government contracts.
The risks in outsourcing should not come as a surprise. When feasibility studies of outsourcing are conducted, errors may be made which affect the accuracy and completeness of the underlying assumptions. Later, deliberate or accidental mistakes can manifest themselves in inappropriate contracting approaches, poor drafting of contracts, and poor monitoring of execution, and can culminate in poor results. For example, with respect to construction, it is to a public body's advantage to establish control as early in the project as possible; some years ago the firm of Arthur Andersen found that 95% of savings available to the total project could be gained by improved drafting of the contract. Significantly, Atkinson (1994) noted that “big-ticket” contracts were likely to constitute less of a problem than apparently minor contracts, such as those for body repair to public vehicles.
Fraud sometimes appears to have assumed epic dimensions. According to a 1993 survey by the US branch of KPMG Peat Marwick, 75% of the nation's largest companies acknowledged that they had experienced fraud during the previous year. Nearly a quarter of the respondents admitted to losses in excess of $l M; two-thirds reported actual or potential losses of more than $100,000 (Williger, 1994).
While some observers have perceived an upsurge in fraud, others believe that currently well-publicized irregularities have merely emerged from the closet. In any event, fraud is believed to be of archaic origin. In ancient societies man is said to have had a religiously rooted reverence for his social superiors, to whom he felt he ought to bring propitiating “gifts”', as one did to gods, spirits, and demons. “Civilization” dismantled the traditional network, replacing it with a rootless and often abusive bureaucracy. Nonetheless, Molnar (1986) emphasized that the tribal connection has remained as the only genuine political reality in most of the third world. Molnar added that what has changed is not the mentality of bribery, but the amounts which have increased.
Hotten (1993) examined the fraud phenomenon through the Victorian age. He wrote that Margaret Thatcher's call in the early 1980s for a return to Victorian values heralded an outbreak of corruption strongly reminiscent of that age. In Hotten's view, Victorian frauds had soured the image of businessmen in the minds of the people; the Industrial Revolution and the consequent emergence of sophisticated financial and legal networks led to expanded opportunities for fraud. It became and remained true that the law never kept pace with the sophistication of the criminals (Hotten, 1993).
Unsurprisingly, the longevity of the fraud problem has led economists to detect cyclical patterns in corruption and in its management. One model of corruption deterrence exhibits several scenarios of corruption equilibria, i.e., points at which a balance is achieved between audit effort on the one hand and the activities of corrupt officials on the other. (Such a formula could, incidentally, help managers to determine the optimum mix of audit resource allocation and penalties for violators.) Cyclical patterns also provide insights useful to planning and timing actions against corrupt officials (Liu, 1986).
The Causes of Fraud
In this article, the terms “fraud” and “corruption”' are broadly used along the lines of a definition formulated by the US Department of Defense:
…any willful or conscious wrongdoing that adversely affects the government's interests….The following are examples of fraud or other unlawful activity: …charging personal expenses to government contracts; diversion of government property or funds for unauthorized uses; submission of false claims…; intentional mischarging…; regulatory or statutory violations, such as bribery, theft…, graft, conflict of interest, and (acceptance of) gratuities; and any attempt or conspiracy to engage in…the above devices (Larson, 1983).
Recession
Recession has been listed as a primary cause of fraud, based on the views of respondents in several surveys. For example, a majority of Canadian chief executive officers (CEOs), chief finance officers (CFOs) and other executives expected fraud to grow in 1993; harsh economic times were given as the major reason (Marotte, 1993). The prediction turned out to be correct. Recession was also tagged as the prime cause of fraud in a 1993 survey conducted by Ernst & Young in association with Michael Levi in the UK (Ernst & Young, 1993).
Why are recessions important as fraud triggers? Recessions may trap executives who have made extravagant forecasts, or even commitments, based on hope. Such individuals have limited options: they can accept dismissal; seek mercy by citing mitigating circumstances; or cook the books. Ironically, in times of recession, organizations are more likely to scrutinize financial results; consequently, more frauds may be discovered than in better times.
Employee Disaffection
The population of employees who see themselves threatened and, therefore, could turn into potential malefactors has increased. America has experienced waves of employee lay-offs as a result of “restructuring”. Indeed, in some industries restructuring and/or re-engineering seem to have become a way of life, thereby presumably increasing the population of potential fraudsters. In the “good old days” most thieves were said to be middle-aged white males, often driven by personal weaknesses or by need. However, fraud in the US has become an equal opportunity employer; surveys have shown that most people would engage in dishonest behavior if they could rationalize their acts to themselves. Moreover, a new type of “macho” thief has emerged; he or she has always felt misunderstood and unappreciated; accordingly, he or she may set out to “show the boss who is smarter”.
Indifference to Internal Control
Internal control has long been prescribed as an antidote to management or employee fraud. The late criminologist Donald Cressey explained the basics. Before fraud can take place there must be:
- An item worth stealing.
- A potential perpetrator willing to steal.
- An opportunity for the crime to take place.
It follows that successful prevention lies in the isolation of the perpetrator from the asset, and from the opportunity and knowledge required for access. In other words, figurative or literal walls of policies, procedures, devices, and controls need to surround and isolate each factor in the Cressey equation.
It is worrisome that internal control deficiencies have apparently continued, as described in a 1987 survey:
There is a disturbing lack of [those] basic, well defined control mechanisms which text books have been extolling for years. The most obvious control which was absent or deficient in nearly all reported cases was that of separating the functions of a particular process, so that one individual [did] not have absolute control. (Audit Commission, 1987.)
The reasons for widespread lack of interest in internal control in many public bodies can be ascribed to a (possibly misplaced) confidence in the integrity of one's own employees. Managers often dismiss the dangers from potential perpetrators by stating that “we don't have such people working here.” Such managers should be coaxed into accessing public on-line data bases for two reasons. First, to obtain information on persons being recruited for sensitive positions, and second, to become aware of the methodologies of fraud, together with the manner of discovery.
Possible Erosion of Business Ethics
While it remains uncertain whether fraud has actually increased in recent years, Roberta So Karmel, a former commissioner of the Securities and Exchange Commission (SEC), wrote on a decline in ethical values. She characterized the 1980s as the “decade of greed”. She concedes that there is a distinction between greed and market-based solutions to economic and social problems, but asserts that the two had become synonymous by the end of the 1980s. She reinforces her point by saying that the SEC shifted its regulatory policies to accommodate the then-current infatuation with the market: “Although the SEC maintained a tough enforcement stance [in insider trading cases], it favored the market for corporate control that fuelled the leveraged buyout, and did not campaign for regulatory reform after the 1987 stock market crash” (Karmel, 1990).
In spite of reports of widespread greed, it should not be assumed that the US has become a modern Sodom and Gomorrah . About a dozen years ago, more than 350 large American corporations notified the SEC of illegal or questionable payments at home and abroad. Yet, these admissions of guilt involved only 3% of public companies; further, most of the amounts were small, both on an absolute basis and on a relative basis, considering the sizes of the corporations concerned. Nevertheless a widely reported low state of morals and ethics has led US business schools to offer courses in ethics, which have proved surprisingly popular.
Difficulties of Teaching Ethics
Teachers of business ethics have not found their task easy, although some signs of improvement may be discerned. The following points can be considered:
- Some ethicists, including the late Bishop Fulton J. Sheen, have maintained that ethics cannot be taught, but have to be practiced.
- It is difficult to choose the appropriate framework for ethical decision making; in any event, most ethicists have now decided on a deontological (i.e. rights-oriented) approach which minimizes the violations of the rights of the various “stakeholders”.
- Outside the US , discussion of ethical issues has long been dogged by assertions of “relative” (i.e., national) rather than universal views of morality; leading ethicists now promote reasoned agreements as to what is morally right.
- Followers of the University of Chicago economist Milton Friedman have interpreted a manager's agency responsibility as constrained by the need to obey the law, to keep a firm's strategic interests in mind, and to respect a minimal set of ethical values. That argument is no longer correct, either politically or ethically, and most people now recognize that business decisions may inflict massive harm on stakeholders not directly involved in a company's dealings.
Some ethicists (Baum, 1994) believe that ethics training should focus on day-to-day decision-making by the trainees, rather than on “war stories” stemming from well-publicized audit failures. A blend of religious and philosophical materials, overlaid by pragmatism, could be useful in demonstrating moral decision-making.
Technological Complexity
Advances in technology have been blamed for facilitating fraud. For example, the Canadian firm of KPMG Peat Marwick Thorne (Marotte, 1993) cites “more sophisticated criminals and inadequate training of people to sniff out fraud”. The sophistication of the fraudsters is arguable; Joseph Wells, founder of the Association of Certified Fraud Examiners, wrote that “fraud is often not well concealed and that half the instances of fraud are discovered by accident” (Wells, 1997). (However, the inadequate training of the watchdogs cannot be gainsaid.)
Technological developments may have facilitated some fraud in a round-about fashion. Some existing systems have been rendered obsolete by growth in the volume of activity and by the emergence of transactions not foreseen when the systems were developed. (For example, Prawiro, Finance Minister of Indonesia , has vividly described his nation's outgrowing of its systems, together with the consequences.)
Safeguards Lag Irregularities
Hotten (1993) commented: “It wasn't until the 1920 Companies Act that entities were to keep detailed books and provide profit and loss statements, and that balance sheets had to separate fixed from floating assets. UK regulation did not fall into line with stricter US and European law until the 1948 Companies Act. The establishment of a police fraud squad, recommended by MPs in 1937, was not undertaken until 11 years later”. Given this historic pattern, it is not surprising that the current inclination toward entrepreneurialism has far outstripped the pace at which reforms, incorporating appropriate controls, are carried through the system.
In view of the lag in reforms, heads of both public and private sector organizations and their security experts should brainstorm opportunity areas for graft and corruption. Such areas include the awarding of contractors, purchasing of equipment, and financing of large projects (Briones, 1987). A major new item needs to be added: studies relating to the outsourcing of public services.
A Related Issue: Whither the Auditors?
In general, US external auditors (and to some extent internal auditors) have detected few frauds leading to business failures. For example, a senior official of the US General Accounting Office (GAO) stated that 87% of savings and loan failures in Texas were caused by management fraud and that external and internal auditors had not detected a single case.
The American Institute of Certified Public Accountants (AICPA) has yet to make an unequivocal pronouncement as to the auditor's responsibility for the detection of material fraud. The AICPA has even been slow to update its own rules on audit skepticism, ignoring the recommendations of the Treadway Commission, which it had co-sponsored. (The National Commission on Fraudulent Financial Reporting is often referred to by the name of its chairman, former SEC Commissioner Treadway. The work of the Commission was sponsored and overseen by an alliance of professional organizations, and its prescriptive report was issued in 1987; implementation has been spotty.)
Some might argue that US authoritative professional literature already makes 33 separate references to audit scepticism. For example, auditors have been directed to assume neither that the management is dishonest, nor that it is of unquestioned honesty. Auditors have been told to recognize that conditions observed and evidential matter obtained, including information from prior audits, need to be objectively evaluated to determine whether the financial statements are free of material misstatement. When an auditor concludes that policies or procedures are ineffective, his response may involve heightening professional scepticism, assigning more experienced staff, and changing the nature, timing and extent of substantive procedures.
SEC rules have long been part of the audit scepticism literature. The SEC urged the auditor to “carry out his examination with an attitude of healthy scepticism which seeks corroboration of explanations offered for matters that have aroused questions in his mind, particularly when those explanations come from individuals who could have personal reasons for diverting further inquiry” (SEC, 1974).
Since the detection of fraud has continued to languish as a secondary audit objective, it should not surprise us that the audit procedures seen as most productive for a fraud investigator (including analytical review, behavioral interviews, plant tours and substantive tests) are often performed by an audit firm's least experienced help.
Audit scepticism should serve as the basis for a redesigned model of the audit process, which calls for extensive use of technology leavened by knowledge of the client's business. Audit attention should center on the principal external and internal threats which confront clients, and on their management and control by the client. Audit procedures would focus on independent verification of management representations and assertions through gathering external data, or by using operational information, with its cachet of semi-independence to confirm and validate financial information. In typical circumstances, auditors would opt for unrestricted (and newly cost-effective) substantive tests, usually performed at year-end. Computer-assisted audit techniques would add rigor and discipline to the examination. The public on-line data bases would play an ubiquitous role, both in assessing risk, and in auditing individual accounts (Pomeranz, 1992).
Conclusion
Approaches to fraud prevention and detection must focus on controlling apparent causes and specific threats. In addition, ways must be found to close the time gap that exists between innovative types of fraud and delayed regulatory, professional, or governmental elimination of the weakness. Greater attention must be given to internal control and its monitoring; the attitude towards internal control reflects an agency's commitment to accountability.
The model of the audit process requires revision and updating. Technology has made it possible to conduct audits that are both efficient and effective. Unrestricted substantive testing is likely to become routine, with senior personnel heavily involved in performing sensitive audit steps. The risk to the audit profession of not moving forward may be best stated in a quotation from the Pakistani philosopher Iqbal: “On this road halt is out of place; a static condition means death” (Malik, 1971).
Sources:
- Atkinson, D. (1994), Warning of rise in public sector fraud. Guardian, 28 January 1994 , p. II.
- Audit Commission (1987), Survey of Computer Fraud and Abuse. HMSO, London
- Baum, R. (1994), Dr. Robert Baum is Director of the Institute for Applied Professional Ethics at the University of Florida . Dr. Baum told the author that ethics should be taught via the details of everyday professional experiences
- Briones, L. M. (1987), On containing graft and corruption. International Journal of Governmental Auditing, 14, 2, pp. 13-14.
- Darch, M. (1994), Corruption cause for concern. Independent, 21 Apri1 1994, p. 5.
- Ernst & Young (1993), Business ignores risk of rising fraud to its cost, warns Ernst & Young. Press Association News File, 10 May 1993.
- Hotten, R. (1993), Fraud city. Independent, 5 September 1993 , p. 14. The introductory quotation comes from an 1866 issue of the law journal Temple Bar.
- Karmel, R. S. (1990), A decade of greed. New York Law Journal, 1 March 1990 , p. 366.
- Larson, J. S. (1983), Fraud in government programs: a secondary analysis. Public Administration Quarterly, 73, pp. 274-293.
- Liu, F. T. (1986), A dynamic model of corruption deterrence. Journal of Public Economics, 31, November 1986, pp 215-293.
- Malik, Hafeez (1991), Iqbal: Poet-Philosopher of Pakistan . Columbia University Press, New York , p. 180. The quotation is from Muhammad Iqbal's Bang-i Dara [The Call of the Highway].
- Marotte, B. (1993), Recession boosts fraud scams. Ottawa Citizen, 11 May 1993 , p. D15.
- Molnar, T. (1996), The culture of corruption. National Review, 38, 24 October 1986 , p. 46.
- Pomeranz, F. (1992), The Successful Audit: New Ways to Reduce Risk Exposure. Richard D. Irwin, Homewood .
- Securities and Exchange Commission (SEC) (1974), Accounting Series Release 153.
- Wells, J. T. (1990), Six common myths about fraud. Journal of Accountancy, February 1990, pp. 82-88.
- Williger, S. D. (1994), Phar-Mor: a lesson in fraud. Wall Street Journal, 28 March 1944 , p. A12.
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