A former auditor looks to the accounting frauds of the past and examines whether the present is any different.
Once upon a time I was an auditor with Andersen in Dubai.I had joined in December 2000.Exactly two years later and my career and
that of tens of thousands of others worldwide was in serious danger because of what had happened thousands of miles away in Houston.
Ever since Enron went bust in late 2002 I’ve been fascinated by accounting scandals and there have been many including some
big names; WorldCom, Global Crossing,Parmalat, Lehman Brothers, Xerox,Halliburton, Tyco etc. They happened due
to three reasons- Pressures, Opportunities and Rationalizations. If there are good reasons to do bad things (mostly moneyrelated), some clever ways of doing it and a good alibi then CEOs and CFOs may not hesitate to as a greedy and incompetent ex CEO of mine so elegantly put it, “enhance their personal net worth”. Fraudulent financial reporting is relatively rare, but these cause the most damage.
From an internal audit and external audit perspective one can focus on all or some of these three factors. The existence of opportunities does mean that fraud is likely to happen. But if there are strong pressures you must be watchful because fraud is far more likely to happen.
Common examples of pressures are high debt levels, impending breach of a debt covenant, increasing competition,declining industry fortunes, operating losses, personal guarantees in debts of the entity, significant financial interests in the entity, new accounting or regulatory requirements, high revenue or profit targets and compensation tied to stock prices/sales/profits. The last mentioned
is probably the most common, which calls into doubt the conventional wisdom of performance linked executive compensation. As an example, almost 90% of the compensation of Enron’s C- suite executives was not in the form of salaries. Re: industry issues, the massive
scandals at WorldCom and Global Crossing were mainly due to the vast oversupply in telecom capacity in the late 1990s.
The Opportunities are many. Significant related party transactions. Domination of management by a single person/group of people. But the most common manipulations happen when estimates and judgement are required and accounting is rife with such instances. Useful lives of depreciable /amortizable assets. Salvage values. Selling prices for calculating net realizable value of inventory. Impairment of fixed assets, goodwill and investments.Fair value of investments. Percentage completion for revenue and cost recognition. Goodwill on acquisition.Provision for doubtful debts and obsolete inventory. Pension liability and pension expense (for a defined benefit pension
plan). The list goes on and it is truly a treasure chest for a cunning CFO. Rationalization is the weirdest of the three as it is mainly psychological and invisible.It’s all about attitude. It’s the fraudster convincing himself that it’s OK that it is only a small amount. That is a big amount but it is just temporary. That it is big but I won’t do it again. That it didn’t hurt anyone. That everyone else is doing it…….
One big red flag is frequent change in external auditors.
One important part of rationalization is the culture of the company. Enron had a toxic culture, a dog eat dog world where revenues and profits were paramount. The weekly Andersen partner meetings with the Anderson CEO (Joe Berardino) always focused on one thing- new clients and firm revenues. Andersen was the only Big 5 audit firm to allow the partner in charge of an audit to override a ruling made by the
quality control partner. In Fannie Mae, if you ever dissented your career was over
Images of external auditors shredding documents come to mind when looking at the accounting scandals of the past
All three factors must be present for fraud to take place. For example if there is a terrible pressure and a fraudulent mindset but no opportunity then fraud is unlikely to happen. Or if there is both opportunity and rationalization but no motivation we have no problems.
Of the three elements, a company can only control opportunity. So, if a company wants to reduce the chances of fraud, they need to eliminate the one element they can: opportunity. One way opportunity can be controlled is by implementing and enforcing good internal controls.
LOOKING TO THE PAST
If you look at history, neither external nor internal auditors have come out of all these accounting scandals smelling of roses.
Since this is a magazine for internal auditors, let us focus on them. There is a spectrum here: from proactivity to inertia
to outright collaboration in the fraud:
- In the case of WorldCom, it was the team led by Cynthia Cooper, Head of Internal Audit, that picked up the nearly USD 3.8 billion overstatement of profit (Done by the relatively simple expedient of capitalizing expenses!). More about her later.
- In most of the other scandals, the internal auditors didn’t bring the scandal to the public eye. Either they were incompetent or they were simply too scared to tell the truth.
- Inaction is unacceptable but the prize for outright collaboration goes to the boys at Satyam, the large Indian IT company. Satyam inflated revenue by creating fictitious invoices on fake clients which led to fake receivables,fake cash, fake interest on the fake cash etc. All this fell apart in 2008 and it was discovered that the Head of Internal Audit helped in setting up the fake customer accounts!.
I believe Internal Auditors have far more responsibility to pick up accounting frauds.Unlike the external auditors whose scope
(and hence the nature, extent and timing of their tests) is strictly defined by Statute and Audit Standards. Internal audit has
a far wider scope that covers not just the financial statements but also operations,propriety etc. The internal auditor knows
the industry, the company and the issues much better than an external auditor.If he is competent, bold and has independence
we should not have any problem.
And it’s not easy. When Ms. Cooper first saw a USD 500 million capitalization at WorldCom that was clearly wrong she talked to the auditors (Andersen) who first told her that the accounting practices were OK and then refused to cooperate with her. She disagreed with her CFO and took the matter to the audit committee of the Board. The Board agreed with her. The CFO was furious and warned her to mind
her own business. Her team secretly spent countless late nights digging into the IT system analyzing hundreds of thousands of entries. Repeatedly blocked by her CFO and Andersen, she went to the new auditors, KPMG who supported her. Her decision to finally go to the board with the evidence was a difficult one; she knew that people would be fired, that WorldCom would suffer massively, that she and her
team could lose their livelihoods and also be blamed for the mess. On 20 June 2002 she presented her findings to the Board.
The next day the Board issued a press release detailing the fraud and it created corporate history.
IS THE PRESENT ANY DIFFERENT?
No it is not! Has anyone heard of the Toshiba accounting scandal (2015)? Richard Chambers, President of the Institute of Internal Auditors, wrote a blog about it 1 and how internal audit didn’t manage to detect this USD 1 billion accounting fraud. However, is fraud really
detected by internal auditors? According to a 2016 study by the Association of Certified Fraud Examiners, internal auditors only detected fraud in 16.5% of the cases with tips from employees being the most common way fraud is detected. In the Middle East, internal auditors seem to do a better job at detecting fraud, as they detected fraud in 25.3% of the cases.Furthermore, when it comes to external auditors, the results are even worse.Globally they detected 3.8% of fraud while in the Middle East the percentage dropped to 1.3% of cases.
Today,accounting fraud is alive and well both globally and in the Middle East; if you’ve paid attention to the news over the past few months you would know that a global accounting firm was banned from conducting audits in Saudi Arabia, a result of what was labeled as “accounting fraud”.Both internal and external auditors have a near sacred duty. On all matters concerning their task, I am reminded of
the quote by Edmund Burke, the 18th century Irish Philosopher: “The only thing necessary for the triumph of evil is for good men to do nothing
BINOD SHANKAR, CFA is the Managing Director of Genesis Institute, a leading UAE based financial training company which he confounded.