Corporate Fraud: Huge Losses for Companies

Corporate Fraud

1.      Introduction

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Truthfulness is vitally important and absolutely necessary to the conduct of accounting to maintain the confidence in the truth put by the public in accounting as a profession that guarantees truth. The absence of truthfulness in maintaining and auditing accounts and preparing reports of a business is as a rule caused by the phenomenon of corporate fraud. It is regrettable that corporate fraud in the accounting environment is increasingly becoming more frequent, causing huge losses to companies, employees, and the public and creating problematic situations related to morality and ethics in the workplace. This paper explains the lack of truthfulness in the accounting environment, presents some theoretical explanations of corporate fraud, and analyses some outcome aspects and situations that result from corporate fraud.

2.      Nature of Fraud

Fraud has been defined in a different ways. But all agree that it is a crime and it is definitely immoral. For example, the Michigan Criminal law indicates that:

Fraud is a generic term, and embraces all the multifarious means which human ingenuity can devise, which are resorted to by one individual to get advantage over another by false representations. No definite and invariable rule can be laid down as a general proposition in defining fraud, as it includes surprise, trick, cunning and unfair ways by which another is cheated. The only boundaries defining it are those that limit human knavery. It is the intentional deception of another person, by lying and cheating for the purpose of deriving an unjust, personal, social, political or economic advantage over another person (in Belkaoui 99).

Within a business company fraud can be performed for or against the company. In this case it is called a corporate fraud. Corporate fraud can be prepared by a management representative or an individual in a position of trust. It may include the use of an accounting machine, accounts, and records to produce a false image of the company. Corporate fraud is then a form of dishonest financial reporting. In addition, it may involve a failure of the auditor to notice or reveal inaccuracies or false statements. Corporate fraud is then an audit failure. In all the described cases, the accountant as preparer of financial statements, auditor, or a person that uses stands to suffer considerable losses.

3.      The Incidence of Corporate Fraud

In 1993 KPMG Peat Marwick surveyed the 2,000 largest firms in the United States to determine the amount of corporate fraud in U.S. firms. The 330 responding firms are representatives of the economy. They included manufacturers, insurance firms, health care organizations, public services, and consumer goods firms. In this survey, 76 percent recognized that they had problems with corporate fraud during the previous twelve month period. 81 percent of the respondents reported losses greater than $25,000. Approximately one-fourth of the respondents reported losses of more than $1 million. In sum more than 40,000 individual acts of corporate fraud were reported and the average cost to the firm was about $200,000 per case (KPMG, Fraud Survey 1993).

When asked the question “Do you think that fraud is a major problem for business today?” 76 percent of firms responded “Yes”. Only 2 percent of the responding firms had expectations that the incidence of corporate fraud would diminish in size and 67 percent said that they expect the rate of corporate fraud to become even greater. Economic problematic periods and a weakening of moral and ethical values of the employees were cited by over 75 percent of the respondents as factors partly responsible for this phenomenon.

In should be noted, however, that the KPMG data does not include incidents where corporate fraud went not discovered or unrecognized. According to the authors of this survey, “given the reluctance to respond, or the inability of some companies in our survey to quantify their experiences, it is likely that the actual incidence and cost of fraud is higher than shown in our survey.”

Firms respond to the threat of corporate fraud by taking measures to lessen the possibility that fraud will occur and to increase the likelihood that when corporate fraud takes place in the organization it will be noticed and recognized. These are not simple tasks in firms and particularly large and impersonal companies characterized by complex structures and operations, globalized environment, or decentralization. However, there are management control systems that can contribute to the detection and prevention of corporate fraud and that can be used by organizations. They will be considered later in this paper.

4.      Characteristics of Corporate Fraud

Respondents to the KPMG Peat Marwick Fraud Survey were asked to describe the types of corporate fraud they had been involved in, how the corporate fraud was revealed, and how the corporate frauds happened.

Types of Corporate Fraud

Type of Fraud
Percent

Misappropriation of Funds
20

Check Forgery
19

Credit Card
15

False Invoices
15

Theft
12

False Representation
4

ATM Fraud
4

Manipulation of Checks
3

Accounts Receivable Manipulation
1

Expense Account
1

False Financial Statements
1

Other
5

(Source KPMG, Fraud Survey, p. 2)

How Were Corporate Frauds Revealed?

Type of Occurrence
Percent

Internal Controls
59

Internal Auditor Review
47

Specific Investigation by Management
46

Notification by Customer
38

Accident
32

Anonymous Letter
28

Specific Investigation by Employees
24

Notification by Supplier
13

Notification by Employee
10

Notification by Government Agency
10

(Source KPMG, Fraud Survey, p. 9)

Corporate frauds are also called economic crimes. As it was said before, they are perpetrated generally by officers, people who are responsible for the administration of business, and/or profit center managers of public companies to fulfill their desires or their short-term economic needs. Actually, corporate fraud may be the short-term oriented management manner of performance that creates the need for corporate fraud given the pressure to make current profitability greater in the face of few opportunities and the need to take unwise risks with the company’s economic wealth. As stated precisely by Jack Bologna (1984),

rarely is compensation based on the longer term growth and development of the firm. As a consequence of this myopic view of performance criteria, the executives and officers of many public companies have a built-in incentive or motivation to play fast and loose with their firm’s assets and financial data (10).

In reality, more than force that compels for short-term profitability it is the economic greed and strong desire for possessions and money that destroy social values and individual morality and lead to corporate fraud. Riahi-Belkaoui (1999) indicates that arrests from two categories of corporate fraud have increased considerably: fraud and embezzlement (20). Actually, corporate fraud involves more than just fraud and embezzlement. It also involves a large indefinite number of activities that may give rise to corporate fraud. The rapid growth in corporate fraud in the United States and all over the world is the result of the escaping from duty, responsibility, and business ethics.

5.      Fraudulent Accounting

Corporate fraud is so rampant that in 2002, President George W. Bush established a Presidential Corporate Fraud Task Force to investigate (Lavey 613). This force is intended to investigate significant cases of corporate fraud involving accounting fraud, mail and electronic fraud, money laundering and tax fraud. The President’s Corporate Fraud Task Force defined fraudulent financial reporting as “deliberate or reckless conduct, whether act or omission, that results in substantially misleading financial statements.” In business, fraudulent financial reporting weakens gradually the integrity of financial information and can have an effect upon a number of victims: owners of a company, creditors, employees, auditors, and sometimes competitors. Fraudulent accounting is used by companies that are facing economic troubles. In addition, it is used by those motivated by a foolish or unreasonable inventiveness.

Instances of widespread types of accounting fraudulent practices include: falsifying accounts for one’s own advantage, falsifying or changing records or documents; hiding or neglecting the effects of completed operations from records of documents; presenting transactions that have no substance; applying wrongly accounting policies; and concealing information of great significance.

Accounting fraud shows a deliberate strategy to mislead by deliberate misrepresentation or lies and by altering the information and the information records. Accounting fraud results from a number of reported abnormal behaviors, such as smoothing, biasing, focusing, filtering, and unlawful activities. These behaviors usually take place when managers, employees, shareholders, or investors have a low belief in the probability that presented information can be analyzed and a low belief in the probability that data can be measured and verified (Lavey 613).  Of all these recorded dysfunctional behaviors the one most probable to result in fraudulent financial reporting is the incident of illegal activities by infringement of a private or public law through corporate frauds.

Fraudulent financial reporting does not always start with an illegal activity though. Managers and executives are indicated to select accounting methods depending on their economic consequences. Some studies have proved that managerial preferences for accounting methods and established modes may be different, depending on the probable economic consequences of those methods and established modes. It has been precisely stated that the manager’s choice of accounting methods may depend upon the effect on reported earnings, the degree of shareholder versus manager control of the organization, and ways of deciding managerial premiums (Healy 85-107).  This attempt to use accounting methods to present a good picture of the organization becomes more pressing on managers or executives facing some form of financial trouble, and in need of depicting the economic situation in the best optimistic and hopeful way. This may lead to concealing consciously or delaying the distribution of negative economic information. The next logical step for these individuals is to use fraudulent financial reporting. To hide economic problems and to mislead investors by deliberate misrepresentation and lies, declining and failing firms have used the following fraudulent reporting practices:

1.             untimely recognizing income,

2.             incorrectly treated service leases as sales,

3.             caused inflation of inventory by incorrect application of the LIFO inventory techniques,

4.             added false amounts in inventories,

5.             were unable to recognize losses by means of write-offs and allowances,

6.              incorrectly capitalized or delayed costs and expenses,

7.             added unusual gains in operating income,

8.             overestimated liquid assets,

9.             created “pretended” year-end transactions to increase reported income, and

10.         made their accounting practices known to enlarge earnings without showing the changes (Fedders and Perry 59).

It is often stated that one factor in the growth of fraudulent financial reporting that has escaped close examination is the omission of accounting education institutions. They failed to teach the methods of revealing corporate fraud and the significance of its detection to the entire financial reporting system. It is obvious that there is a need for companies to adopt measures to lessen fraudulent and doubtful financial reporting practices.

6.      Framework for Corporate Fraud in the Accounting Environment

As it has been established above fraud in the accounting environment is taking the shape of corporate fraud. The major issue that emerges is to determine the causes and above all framework for the corporate fraud. Particular characteristics of the individual or the situation that may lead to corporate fraud in the accounting environment abound. For instance, there is a need to watch for “a warning of risk” that do not necessarily prove corporate fraud, but when enough of them are present, there is the considerable potential for corporate fraud. Examples of these particular characteristics to be watchful of in the course of an audit involve the following:

•        An individual who is a wheeler and dealer

•        An individual without a clearly defined code of business ethics

•        An individual who is afflicted by neurosis, has mental disorder, or emotionally unstable and unusually anxious, particularly in stressful situations

•        An individual who is showing an exaggerated opinion of one’s own importance or is very egoistical

•        An individual with a psychopathic temperament

In analyzing the corporate structures and practices that create a favorable combination of circumstances for executives and managers in a firm to commit corporate fraud for corporate benefit, Albert et al. (1987) indicate the following seventeen specific warnings of risk:

1.      Related-party transactions

2.      The use of service of several different audit organizations, or the constant changing of auditors

3.      Unwillingness to give auditors required information

4.      The use of many different legal organizations or the frequent changing of legal advisors

5.      The use of extremely large number of banks. In this situation none of these banks can see the complete picture of economic events

6.      Unceasing problematic situations with several different regulatory agencies

7.      A business structure made up of various interconnected parts

8.      No internal auditing employees capable of producing positive results

9.      High degree of computerization in the company

10.    Insufficient systems-based audit, or failure to reinforce existing systems-based audit

11.    Fast turnover of important employees

12.    Participation in not typical or “hot” industries

13.    Large accounting year and/or extraordinary transactions

14.    Inappropriately liberal accounting practices

15.    Accounting records lacking in quality

16.    Insufficiently staffed department of accounting

17.    Insufficient presentation of doubtful or uncommon accounting practices (p. 66).

While these specific characteristics may be helpful for a detection of the possibility of corporate fraud, they do not give sufficient normative explanation of why corporate fraud takes place in the organizations. The study of criminal behavior, however, presents various models and theories that are very much applicable to corporate fraud in the accounting environment and can offer alternative clarifications for this phenomenon.  One of such theories is Anomie Theory.  It offers alternative explanation for the phenomena of corporate fraud.

Anomie as introduced by Durkheim. It is a state of normlessness or lack of social or moral standards in an individual or society, a disordered relationship between the individual and the social order, which can explain various forms of dysfunctional behavior in modern corporate environment (Lilly, Cullen, and Ball, 28).  In their striving to achieve the American dream, people may find themselves in a situation necessitating a choice between cultural goals and the means needed to achieve them, leading to seek ways to choose new techniques.

Among these ways are innovations and organized resistance. Innovation is associated with the use of illegal means to achieve success and may explain corporate fraudulent practices. Corporate fraud practices are a result of anomie in modern societies. In essence, delinquent accountants become apparent among those individuals whose status, power, and security of income are comparatively low but whose level of strong desire and ambitions is high, so that they make efforts to come up to the surface from the bottom even using illegal ways, such as corporate fraud. Fraudulent activity among financial representatives is then the solution to anxiety related to social and professional position. Corporate fraud results from the disagreement between the commonly accepted values of ambition and success and the inability to realize them, and the presence of particular unlawful means.

7.      Corporate Fraud – The Employee’s Perspective

Systems of management control are very important for the prevention and detection of corporate fraud. Corporate fraud should be approached from the perspective of the company and its employees. In addition to the ethical development of corporate employees, they should be taught the basic principles of management control systems. Poorly designed or incorrectly implemented systems of management control produce a climate leading to corporate fraud.

At the same time, an appropriately built and implemented management control system is in itself not a sufficient reaction to the problems related to corporate fraud. Mistakes, secret agreements, crimes by management, failure to give due attention, and changes in the type and nature of business operations are instances of factors that cause management control systems to be unsuccessful in an attempt to prevent corporate fraud. Besides a well designed management control system the company must to give emphasis to factors that include: personnel practices that attract and keep competent persons committed to honesty; a growing commitment from top executives, including the board of management, to training and the maintenance of a corporate culture that strives to prevent and reveal corporate fraud; and internal and external audits that discourage fraudulent corporate practices and let corporate personnel and other interested parties in the company to determine the effectiveness of control mechanisms (Riahi-Belkaoui 97).

8.      Management Control

A management control can be described as “an initiative chosen because it is believed that the probability of obtaining the desired outcome will be increased” (Geary 74). This definition of management control emphasizes conscious designs, beliefs, and possibilities. Management controls are consciously designed to accomplish a particular objective such as having an effect upon the behavior of employees of the company in order to achieve a goal. Management control designs embody the beliefs and assumptions of the planners. The creation and implementation of controls is supposed to increase the probability that the results will be achieved. The main elements of purpose, opinion, idea, and probability determine both the strong and the weak sides of management controls.

An all-inclusive system of management controls is a system of control initiatives that includes planning, performing, and analysis of results. Planning stage emphasizes management purposes, ideas, and beliefs and considers questions such as: Where are we exposed to risk of corporate fraud? How can we determine and analyze control risks? What control measures are accomplishable and cost reasonable? What do we believe will be capable of producing a good result and why will it accomplish an objective? The principles, propositions, ideas, and experiences of management considerably influence their evaluation of control risks and the logical consequences related to intended control initiatives. Management education will hence continue to be an element of great importance in taking measures in regard to the problem of corporate fraud.

At the stages of performance and analysis of results both the competence of planning and the reasonableness of beliefs can be judged in terms of the nature and occurrence of observed corporate fraud problems. Performing control gives emphasis to the probability of occurrence and the probability of a timely and sufficient response to corporate fraud problems. At the performing control stage companies must observe and analyze performing activities, make amendments to the plan as needed, and react appropriately to events that depart from expectations. Activities related to the analysis of results involve the formal and informal means of evaluating performing outcomes. Analysis of results provides an essential background for performance evaluation and for corrections to future planning and performing stages (Bologna 1984).

9.      Conclusion

There is undoubtedly an emerging problem for the accounting profession arising from the increase of corporate fraud in the modern accounting environment. Corporate fraud is a major concern for today’s businesses. The trust in the accounting profession and the accounting field as a guarantee of the honesty of financial recording systems will be set at a risk more unless serious and profound measures to decrease the corporate fraud problem are taken. The seriousness of the phenomenon should be emphasized in special courses in the ethical issues of the accounting profession. The education institutions should take the lead in making the students more sensitive to the existence, the seriousness, importance, the immorality, and the unpleasant results of the problem. The long-term-oriented management control techniques that may lessen a large proportion of corporate fraud should be designed and implemented in the corporate settings.

Works Cited

Albert, W. Steve et al. How to Detect and Prevent Business Fraud. Englewood Cliffs, N.J.: Prentice-Hall, 1987, p. 66.
Belkaoui, Ahmed. The Coming Crisis in Accounting, Westport, Conn.: Quorum Books, 1990.

Bologna, Jack. Corporate Fraud: The Basics of Prevention and Detection. Boston: Butterworths, 1984.

Fedders, John M. and Perry, L. Glenn “Policing Financial Disclosure Fraud: The SEC’s Top Priority,” Journal of Accountancy, July 1994, p. 59.

Geary, W. T. “Financial Control,” in Behavioral Accounting, eds. G. Siegel and H. Ramanauskus- Marconi, Cincinnati, Ohio: South-Western, 1989, p. 74.

Healy, P. M. ‘The Effects of Bonus Schemes on Accounting Decisions,’ Journal of Accounting and Economics, 1-3, 1985, pp. 85-107.

KPMG Peat Marwick, Fraud Survey Results 1993, New York: KPMG Peat Marwick, 1993, p. 2.
Lilly, J. Robert, Cullen,Francis T. and Ball, R. A. Criminology Theory: Context and Consequences, Newbury Park, Calif.: Sage, 1989.

Lavey, Warren G. ‘Responses by the Federal Communications Commission to WorldCom’s Accounting Fraud.’ Federal Communications Law Journal, Vol. 58, 2006, p. 613.

Riahi-Belkaoui, Ahmed. Corporate Social Awareness and Financial Outcomes. Quorum Books: Westport, CT, 1999.

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