|
OCTOBER 2000: This guide lists opportunity red
flags, personal characteristic red flags, and situational pressure red flags
of possible fraudulent activity. It also provides indicators of possible
fraudulent activity for various business processes including accounts
payable process, purchasing process, payroll process, cash receipts process,
accounts receivable process, inventory/production process, and finance
process.
-
It provides a thorough list of indicators to
watch for which may signal fraudulent activity by individuals against the
company.
-
The list of indicators is broken down into
categories to help identify signs of personal fraud, individual fraud on
behalf of the company, and management fraud on behalf of the company.
-
This guide also provides Fraud indicators
for various business processes
(Read
more...)
Is There a Link Between Executive Compensation and Accounting Fraud?
FEBRUARY 2004: This study investigates the
association between the structure of executive compensation and accounting
fraud. We study 50 firms accused of accounting fraud by the Securities and
Exchange Commission (SEC) during the period 1996-2003 as compared to firms
not accused of accounting fraud during the same period. We find that the
probability of accounting fraud is increasing in the percent of total
executive compensation that is stock-based (termed stock-based mix) after
controlling for governance characteristics, financial performance, financial
distress, firm size, and the likelihood of management wanting to obtain
external financing. We find that while the unconditional likelihood of
accounting fraud is small, a one standard deviation increase in the
proportion of compensation that is stock-based increases the probability of
an accounting fraud by approximately 68%. (Read
more...)
Executive Compensation
and Corporate Fraud
APRIL 2005: Executives at fraud firms face
greater financial incentives to commit fraud than do executives at industry-
and size-matched control firms. After controlling for various firm,
governance, and CEO characteristics, the likelihood of fraud is positively
related to incentives from unrestricted stock holdings and is unrelated to
incentives from restricted stock and unvested and vested options. Executives
at fraud firms exercise larger fractions of their vested options, sell more
stock, and receive greater total compensation during the fraud years than
the control executives. Operating performance measures suggest executives
commit corporate fraud following declines in performance. Stock prices fall
approximately twenty percent on average upon the disclosure of potential
fraud, which suggests that frauds inflated stock prices during the fraud
period. Our results imply that optimal governance measures depend on the
strength of executives’ financial incentives, especially following periods
of poor performance, and that restrictions on an executive’s ability to sell
shares could deter fraud. (Read
more...)
Board Composition and
Corporate Fraud
The study reported here examined how various
characteristics of the board of directors and other governance features
affected the occurrence of U.S. corporate fraud in the 1978–2001 period. The
findings suggest that board composition and the structure of a board’s
oversight committees are significantly correlated with the incidence of
corporate fraud. In the sample, as the number of independent outside
directors increased on a board and in the board’s audit and compensation
committees, the likelihood of corporate wrongdoing decreased. (Read
more...)
The Effective use of Benford's Law to Assist in Detecting Fraud and
Accounting Data
2004: Benford's Law has been promoted as
providing the Auditor with a tool that is simple and effective for the
detection of fraud. The purpose of this paper is to assist auditor in the
most effective use of digital analyses based on Benford's Law. (Read
more...)
A Comprehensive Survey of Data Mining-based Fraud Detection Research
SEPTEMBER 2005: This survey paper categorises,
compares, and summarises from almost all published technical and review
articles in automated fraud detection within the last 10 years. It defines
the professional fraudster, formalises the main types and subtypes of known
fraud, and presents the nature of data evidence collected within affected
industries. Within the business context of mining the data to achieve higher
cost savings, this research presents methods and techniques together with
their problems. Compared to all related reviews on fraud detection, this
survey covers much more technical articles and is the only one, to the best
of our knowledge, which proposes alternative data and solutions from related
domains. (Read
more...)
Managing the Risk of Fraud - Actions to Counter Fraud and Corruption
OCTOBER 2006: This guidance describes what
action is needed for an organisation to be effective in countering fraud and
corruption. It is intended to provide support to organisations and
individuals in all sectors of the economy. (Read
more...)
Key Elements of
Antifraud Programs and Controls
AUGUST 2003: Companies subject to
Sarbanes-Oxley must now implement "antifraud programs and controls" that are
evaluated annually during the integrated audit. This paper spells out the
key elements of such a program, based on the core principles shared by the
new law, regulations and standards: prevention and timely detection. The
paper applies the five elements of the COSO Internal Control—Integrated
Framework to enumerate the attributes of good design and operating
effectiveness and to provide guidance regarding the types of auditing
deficiencies that may result when one or more of the key elements is absent
or ineffective. The paper includes a quick reference guide of actions to
consider. (Read
more...)
Taking Control: A Guide to Compliance with Section 404 of the Sarbanes-Oxley
Act of 2002
AUGUST 2004: To assist companies with their
Sarbanes-Oxley section 404 compliance projects, we have released Taking
Control, a comprehensive, plain-English guide to implementing a strong
system of internal control.
Taking Control can benefit a variety of
readers:
-
Nonaccelerated filers and foreign private
issuers who may just be getting their 404 work under way
-
Public companies at various stages in their
section 404 projects
-
Nonprofit organizations, governmental
agencies and other groups that are not mandated to comply but who wish to
adopt some of the good governance practices outlined in Sarbanes-Oxley
-
Executives and board and committee members
who can gain insights from the "Executive Overview" and "Lessons Learned"
sections
-
Employees “on the ground” who can find
practical advice distilled from real-world experience in the
"Implementation Guide" section
(Read
more...)
Developing a Fraud Profile
Method
JUNE 2005: Fraud is a particular crime. It
does not usually involve violence but can have devastating effects on the
lives of people and the efficacy of institutional governance. This paper
presents macro and micro level cases in a collaborative
practitioner–academic project to develop a more robust method for
understanding, investigating and preventing fraud. It is part of the
contribution to ethical and effective institutional governance.
The investigative methodology arises in part
from two sources: Ernst and Young experience in investigations and fraud
prevention across different sectors in an economy and across cultural and
legal jurisdictions, and academic expertise in ethics and management
systems. It contributes an analytical tool more proactive in managing risk
within public and private enterprises, which is more strategic, focused and
cost effective. (Read
more...)
Guide to Preventing Workplace
Fraud
2006: Regardless of size, all organizations
are vulnerable to workplace fraud. Fraud can take many forms including
embezzlement, forgery, theft of inventory and other assets, and computer
crime—and can continue unchecked for years. The financial impact on an
organization of these so-called “whitecollar” crimes can be devastating.
This booklet discusses the threat posed by
various types of fraud, reviews common types of fraud schemes, and suggests
specific risk management strategies. (Read
more...)
Key Fraud Prevention Controls
This document outlines a number of ‘best
practice’ controls which should be in place to combat the more common types
of fraud perpetrated against public sector bodies. It is not an exhaustive
list, but if all of these controls are in place and are being complied with,
Practices can significantly reduce the risk of loss from fraud in these
areas by either prevention or detection at an early stage. It is worth
pointing out however, that many controls will fail in the face of collusion.
It should be noted that these controls are
only those specifically identified as fraud prevention controls and do not
represent our idea of what should constitute the total control framework in
these areas. (Read
more...)
Principles, Processes and Practices of Fraud Prevention
DECEMBER 2007: It is well known that fraud is
rarely perpetrated by one individual alone. In most instances, fraud is a
result of collusion between two or more individuals and/or entities. My hope
is that this research can be used to focus some ineffective efforts taken by
regulators, senior executives, independent directors and, at times,
auditors, to focus on the elements which contribute most to fraud. Only a
joint, synchronized, and sustainable concerted effort by all parties
involved in financial reporting can bring focus to the most important
elements of fraud.
The purpose of this research project is to
study corporate, financial reporting fraud, and associate principles,
processes, and practices. (Read
more...)
Determinants
of Customs Fraud and Corruption
AUGUST 1998: Corruption in customs
administrations is a major problem in many African countries. Data
from the period 1990-96 are used to examine several hypotheses
concerning the determinants of customs fraud in Senegal and Mali.
Statistical tests using product-by-product data support the widely
held view that high levels of taxation lead to fraud. The findings
also show that hiring a pre-shipment inspection company can be an
effective tool in fighting corruption, but only if it is
accompanied by internal reforms like computerisation of customs
procedures. (Read
more...)
The Impact of
Insurance Fraud Detection Systems
OCTOBER 2003: The purpose of this
paper is to characterize the impact of fraud detection systems on the
auditing procedure and the equilibrium insurance contract, when a
policyholder can report a loss that never occurred. Insurers can only detect
fraudulent claims through a costly audit (costly state verification). With a
fraud detection system insurers can depend their audit on the signal of the
system and auditing becomes more effective. This paper presents conditions
under which insurance fraud and the resulting welfare losses can be reduced
by the implementation of a costly fraud detection system that is supplied by
an external third party. (Read
more...)
Management Turnover and Governance Changes following the Revelation of Fraud
APRIL 1999: Fraud scandals can create
incentives to change managers in an attempt to improve the firm's
performance, recover lost reputational capital, or limit the firm's exposure
to liabilities that arise from the fraud. It also is possible that the
revelation of fraud creates incentives to change the composition of the
firm's board, to improve the external monitoring of managers, or to rent new
directors' valuable reputational or political capital. Despite such claims,
we find little systematic evidence that firms suspected or charged with
fraud have unusually high turnover among senior managers or directors. In
univariate comparisons, there is some evidence that firms committing fraud
have higher managerial and director turnover. But in multi-variate tests
that control for other firm attributes, such evidence disappears. These
findings indicate that the revelation of fraud does not, in general,
increase the net benefits to changing managers or the firm's leadership
structure. (Read
more...)
An Examination of Actual Fraud Cases With a Focus on the Auditor’s
Responsibility
MAY 2007: The purpose of this paper
is to contribute to an understanding of the intricate relationship between
audit regulation and developments in audit practice in relation to the fraud
issue. The extent and exact nature of the responsibilities of the auditor to
detect fraud in relation to audit engagements has been widely discussed over
the years. In this paper we classify actual cases, where the
responsibilities of auditors have been established by the court system
and/or by the auditors own professional organizations in Denmark. The
dataset includes all publicized cases raised against Danish auditors within
the time period 1909-2006. The information provided in the cases provides a
basis for identifying the actual responsibilities pertaining to fraud during
the audit. The overall finding of the historical analysis is that the
responsibilities of the auditor in relation to fraud should be interpreted
not as a group of its own, but in line with the development of what
constitutes a good audit in general. (Read
more...)
A primer on new techniques used by the sophisticated financial fraudster
MARCH 2003: Financial instruments
such as documentary credit, structured finance and derivatives have proved
their value in commodity trade. However, the sophistication of these
instruments can also make them a tool for financial fraud. This report
discusses how, using commodity market instruments such as letters of credit,
warehouse receipts, Special Purpose Vehicles, futures and swaps, the
sophisticated financial fraudster may try to trick bankers, commercial
counterparties, Government regulatory or tax offices, and shareholders.
Various techniques that have been used in the past are described, and
illustrated with case studies (e.g. the salad oil swindle, Solo Industries
and Enron). Ways in which Governments, banks and commodity firms can reduce
the potential for such frauds are summarized in the report’s conclusion. (Read
more...)
Is occupational fraud "typical" white-collar crime? A comparison of
individual and organizational characteristics
2005: Controversy over the
appropriate unit of analysis plagued the white-collar crime literature. This
state of affairs was a product, at least in part, of the continued
development of two distinct research traditions. Researchers interested in
"occupational crime" focused on individuals, whereas "corporate crime"
researchers studied organizations. As a result, assumptions persisted about
the "typical" offender and organizational setting for white-collar crime.
Using a sample of 1,142 occupational fraud cases, the present study
addressed voids in the literature by comparing differences in individual
offender characteristics (i.e., age, gender, education, and position in the
organization) and organizational victim characteristics (i.e., size, type,
existing control mechanisms, and revenue) for three types of occupational
fraud: asset misappropriation, corruption, and fraudulent statements. The
analysis revealed that individuals who committed fraudulent statements
conformed to the literature's "high status" image, while those involved in
asset misappropriation or corruption more closely resembled "middle-class"
offenders. (Read
more...)
Fraud in American organizations: An examination of control mechanisms
AUGUST 2004: According to estimates
form a recent U.S. survey, approximately 6% of 2002 revenues were lost
through fraud committed by employees. When considered in the context of the
U.S. gross domestic product, this figure translates to nearly $600 billion
in losses. These alarming statistics underscore the need for a thorough
assessment of methods that organisations can utilise to detect and prevent
fraud from within. This study focuses on a form of white-collar/occupational
crime and occupational fraud. Consistent with prior white-collar crime
research, occupational fraud is conceptualised as an act that violates
trust. Using data from 663 occupational fraud cases in 4 U.S. organisational
setting (i.e., government agencies, non-profit agencies, private business,
and publicly-traded companies), the study evaluates whether the presence of
internal control mechanisms impacts organisations' median dollar losses from
fraud. Implications for future research and fraud prevention in
organisations are discussed. (Read
more...)
The Money Laundering
Prevention System
The paper presents the money
laundering and terrorist financing prevention system in Croatia. The basic
concepts are defined, the principles and fundamentals of international
regulations analysed, and the regulatory system in Croatia covered by
statute and money laundering prevention Regulations is presented, in
conjunction with a description of the organisation, remit and international
actions of the Money Laundering Prevention Office. The infiltration of dirty
money is a crucial problem from national economies. The purchase of shares,
of real estate, the establishment of dirty investment funds and the use of
the banking system for the embedding of such resources is a danger to the
credibility of a whole country, and in particular to the security of the
financial and banking system. Croatia has adopted statutory measures aimed
at the effective detection and prevention of suspicious financial
transactions, in other words the prevention of money laundering. Launderers
constantly find new ways, make use of new non-financial channels and expand
their activities to real estate, artworks and insurance. (Read
more...)
Dirty money: after September 11, the fight against money laundering has
acquired new urgency
2002: The first strike against
terrorism after the September 11 attacks on the World Trade Center and the
Pentagon was a financial one. Not two weeks had passed since the attacks
when President Bush signed an executive order freezing the U.S. assets of 27
entities that included terrorist organizations, individual terrorist
leaders, a corporation alleged to be a front for terrorism, and several
nonprofit organizations. In the days and weeks that followed, policies to
impede the covert flow of illicit funds through the global financial system
were among the measures at the heart of Congressional debates on how to
fight terrorism.
This response should come as no
surprise. Measures against money laundering have increasingly become an
important front in the fight against crime. Such measures can facilitate
detection of financial trails that provide important sources of evidence,
potentially linking the members of a criminal organization and leading to
convictions of the ring leaders—who are hard to connect to the day-to-day
criminal operations. Moreover, finding and seizing money or assets that
result from criminal activity can also serve to take the motive out of
crime. And, in the case of terrorist financing, it can make it more
difficult to commit future acts. (Read
more...)
Dishonesty
in Everyday Life and its Policy Implications
JANUARY 2006: Dishonest acts are all
too prevalent in day to day life. In the current review, we examine some
possible psychological causes for such
dishonesty that go beyond the standard
economic considerations of probability and
value of external payoffs. We propose a
general model of dishonest behavior that
includes also internal psychological reward mechanisms for
honesty and dishonesty, and we point to the implications of this model in
terms of curbing dishonesty. (Read
more...)
Money Laundering, Corruption And Growth: An Empirical Rationale For A Global
Convergence On Anti-Money Laundering Regulation
2006: This paper provides empirical
evidence on the impact of anti-money laundering regulations on growth. The
empirical results have led us to confirm a positive relation between low
corruption levels and high investment and growth. We approached the impact
on growth of money laundering prevention (MLP) initiatives in two ways:
first, by verifying that the existence of these initiatives affects the
perception of corruption. Second, by verifying that MLP variables, such as
the ones we are focusing in this article – which criminalize types of money
laundering activities different from those drug-related; make it an
obligation to inform of suspicious financial activities; and establish a
Financial Intelligence Unit (FIU) – showed to be related to growth and
investment. (Read
more...)
Corporate Governance
and Accounting Scandals
OCTOBER 2005: This paper empirically
examines whether certain corporate governance mechanisms are related to the
probability of a company restating its earnings. We examine a sample of 159
U.S. public companies that restated earnings and an industry-size matched
sample of control firms. We have assembled a novel, hand-collected data set
that measures the corporate governance characteristics of these 318 firms.
We find that several key governance characteristics are unrelated to the
probability of a company restating earnings. These include the independence
of boards and audit committees and the provision of nonaudit services by
outside auditors. We find that the probability of restatement is lower in
companies whose boards or audit committees have an independent director with
financial expertise; it is higher in companies in which the chief executive
officer belongs to the founding family. These relations are statistically
significant, large in magnitude, and robust to alternative specifications.
Our findings are consistent with the idea that independent directors with
financial expertise are valuable in providing oversight of a firm’s
financial reporting practices. (Read
more...)
Benford’s Law: Can It Be Used to Detect Irregularities in First Party
Automobile Insurance Claims?
2005: The research described
in this article demonstrates that a digital analysis method called Benford’s
Law can be applied to first-party automobile insurance claim data to detect
number irregularities, which can be used in uncovering fraudulent automobile
claim activity. This work is important because it provides a unique method
of automating the automobile claim fraud detection process at Utica National
Insurance Group (UNIG). Striving for new and different ways to automate this
process sets the stage for more efficient and effective fraud detection both
reactively and proactively. (Read
more...)
The Fraud Management Lifecycle Theory: A Holistic Approach to Fraud
Management.
2004: Fraud losses impact
every business. Caveat Emptor, let the buyer beware, tells half the story;
Caveat Venditor, let the seller beware, tells the rest. Fraud costs are
passed on to society through increased customer inconvenience, opportunity
costs, unnecessarily high prices, and criminal activities funded by the
fraudulent gains. In short, fraud is rampant. This study developed a
theoretical framework for the Fraud Management Lifecycle, examined numerous
significant lifecycle stage interactions, and evaluated the lifecycle in
five industries with significant economic crime.
The Fraud Management Lifecycle
is dynamic, evolving, and adaptive. The eight stages are: Deterrence,
Prevention, Detection, Mitigation, Analysis, Policy, Investigation, and
Prosecution. Effective fraud management requires a balance in the competing
and complementary actions within the Fraud Management Lifecycle. (Read
more...)
An Accountant’s Defining Moments: Questionable Corporate Practices
2004: The image of
corporations that were once held in high regard because of their power and
profits has been damaged recently by alarming news stories about dishonesty
and corruption at their highest levels. In an effort to address public
concerns brought about by the dominant headlines of Enron, WorldCom, Xerox,
Andersen, Adelphia, Tyco, and Global Crossing, among others, Senator Paul
Sarbanes and Congressman Mike Oxley were instrumental in developing a host
of laws to strengthen corporate accountability. Signed into law by President
George W. Bush on July 30, 2002, the bill, the Sarbanes-Oxley Act of 2002,
among other things creates an oversight board to monitor the accounting
industry, toughens penalties against executives who commit corporate fraud,
and increases the authority and funding of the Securities & Exchange
Commission (SEC).
For the purposes of this
study, a survey of accounting professionals was conducted. Using the survey
results, this article will address issues in corporate America surrounding
fraud, waste, and abuse by business leaders, and the concealment of such by
the accountants charged with keeping them in check. The article also
addresses issues and considerations leading up to the Sarbanes-Oxley Act of
2002 and the new rules for corporate accounting and reporting in America.
(Read
more...)
An Eye for an Eye in the Electronic Age: Gauging Public Attitude Toward
White Collar Crime and Punishment
2002: Recent revelations
regarding the indiscretions of corporate leaders in the United States has
forced new attention on white collar crime, how it is treated by the
criminal justice system and how it is perceived by the American public. Past
conventional wisdom has held that the general public considers white collar
crime, especially fraud, as fairly innocuous, especially in comparison with
crimes of physical violence. This article presents results of a national
public survey of 1,169 households throughout the U.S. that challenge some of
these beliefs of public apathy towards white collar crime. (Read
more...)
Anti-Money Laundering - What every Accountant should know (UK)
2004: Organised criminals, and
in particular drug traffickers, generate large amounts of cash. In order to
avoid raising suspicions they must, therefore, make their illegally acquired
wealth appear legitimate, to derive a maximum benefit from their activities.
This process is called money laundering.
A wider definition of money
laundering, as provided by the Financial Action Task Force (FATF), is that
it involves “hiding, moving, and investing the proceeds of criminal
conduct”.
The principle objective of
money laundering is to convert cash to some other form of asset, so as to
conceal the illegal source or origin of the cash income. The criminal will
eventually use these ‘laundered’ funds to cover the tracks of the criminal
activity that initially generated the cash. (Read
more...)
The Press as a
Watchdog for Accounting Fraud
DECEMBER 2003: This paper
investigates the press' role as a watchdog for accounting fraud. In choosing
whether to fulfill this role, the press must trade off the benefits of
providing interesting stories, and thus increasing circulation, with the
costs of identifying such stories and potentially alienating business
partners and advertisers. I use a sample of firms that the SEC has found
guilty of committing accounting fraud to investigate how the accesses these
costs and benefits. I find the press is more likely to write an article
identifying accounting fraud if the firm has a high information environment
(i.e. many press articles in general, high analyst following and, although
weaker results, a large market value of equity). A rich information
environment indicates the press can obtain information at a lower cost and
that a large number of potential readers would be interested in the firm. (Read
more...)
Audit Team Brainstorming, Fraud Risk Identification, and Fraud Risk
Assessment: Implications of SAS No. 99
OCTOBER 2007: SAS No. 99
requires brainstorming sessions on each audit to help auditors detect fraud.
This study investigates audit team brainstorming sessions and the resulting
fraud judgments. Accounting and psychology team literature suggests that
audit teams generally outperform individual auditors. However, the
psychology literature suggests that brainstorming tasks are one exception
because brainstorming teams lose ideas that were previously generated by the
individuals on the team. Results from my experiment suggest that
brainstorming sessions result in an overall loss of ideas generated by
individual auditors prior to the brainstorming session. However, while the
overall number of ideas is reduced, brainstorming audit teams generate more
quality fraud ideas than individual auditors generate before the
brainstorming session. Results also suggest that audit teams' fraud risk
assessments after the brainstorming session are significantly higher than
those assessments given by individual auditors on the team prior to the
brainstorming session, especially when fraud is present. (Read
more...)
A Cognitive Approach to
Fraud Detection
JANUARY 2006: Fraud
detection is usually done by looking for red flags and various other cues of
deceit. Research in auditing and psychology has questioned the effectiveness
of these methods. Here we summarize work on constructing a new cognitive
approach to understanding both success and failure at detecting financial
statement fraud (Johnson, Grazioli, Jamal and Berryman 2001; Johnson,
Grazioli, Jamal and Zualkernan 1992). We begin by analyzing the information
processing problem than an auditor must solve to detect the presence of
deceptive financial information. We then describe a theory of the solution
to this problem, i.e. a theory of successful fraud detection. The theory is
used as a yardstick to evaluate the actual behavior of Big 4 firm audit
partners engaged in the review of real cases of financial statement fraud.
An analysis of the errors made by these auditors allows us to formulate and
test hypotheses on where they succeed, where they fail, and the cognitive
processes that underlie both success and failure. (Read
more...)
Using
Nonfinancial Measures to Assess Fraud Risk
JUNE 2007: For several
decades, the audit profession has attempted to find efficient and effective
methods of improving auditors' fraud risk assessments so as to enhance audit
quality and reduce auditor liability. This study examines whether auditors
can effectively use nonfinancial measures to assess the reasonableness of
financial performance and, thereby, help detect financial statement fraud
(hereafter, fraud). If auditors and other interested parties (e.g.,
directors, lenders, investors or regulators) can identify nonfinancial
measures (e.g., facilities growth) that are positively correlated with
financial measures (e.g., revenue growth), inconsistent patterns between the
nonfinancial measures and financial performance can be used to detect firms
with high fraud risk. Our results suggest that the difference between
nonfinancial measures and financial performance is significantly greater for
fraud firms than for their non-fraud competitors. In short, the fraud-firms'
nonfinancial measures were not consistent with their reported financial
performance. We also find that this difference is a significant fraud
indicator when included in a model containing variables that have previously
been linked to the likelihood of fraud. Overall, our results provide
empirical evidence suggesting that nonfinancial measures can be effectively
used to assess the likelihood of fraud. (Read
more...)
Contemporaneous Risk Factors and the Prediction of Financial Statement Fraud
AUGUST 2006: This study
identifies the contemporaneous risk factors empirically related to financial
statement fraud. Extant research identifies a number of individual factors
related to fraud in various settings. In this study we examine an array of
potential fraud risk factors in order to identify a comprehensive set of
coexistent factors that are consistently linked to the incidence of
financial statement fraud. Further, using the identified fraud risk factors,
we construct a robust fraud prediction model. The analysis yields a number
of significant factors related to pressure and opportunity. Using the
significant fraud risk factors we then construct a fraud prediction model.
The model correctly classifies fraud and no-fraud firms approximately 69.77
percent of the time, a substantial improvement over other fraud prediction
models. (Read
more...)
Decomposition of Fraud Risk Assessments and Auditors' Sensitivity to Fraud
Cues
JANUARY 2004:
Practitioners and regulators are concerned that when auditors perceive
management's attitude or character as indicative of low fraud risk, they are
not sufficiently sensitive to high levels of incentive or opportunity risks
in their overall fraud risk assessments. In this study, we examine whether a
fraud-triangle decomposition of fraud risk assessments (i.e., separately
assessing attitude, opportunity, and incentive risks prior to assessing
overall fraud risk) increases auditors' sensitivity to opportunity and
incentive cues when perceptions of management's attitude suggest low fraud
risk. In an experiment with 52 practicing audit managers, we find that
auditors who decompose fraud risk assessments are more sensitive to
opportunity and incentive cues when making their overall assessments than
auditors who simply make an overall fraud risk assessment. However, this
increased sensitivity to opportunity and incentive cues appears to happen
only when those cues suggest low fraud risk. When opportunity and incentive
cues suggest high fraud risk, auditors are equally sensitive to those cues
whether they use a decomposition or a holistic approach. We discuss and
examine potential explanations for this finding. (Read
more...)
Managerial Incentives
and Corporate Fraud
FEBRUARY 2006:
Equity-based compensation, while inducing greater managerial effort, also
provides incentives for managers to fraudulently inflate a firm's stock
price. This paper examines the owners' optimal contract in the face of these
conflicting incentives when it is sometimes possible for the manager to
commit fraud and the public disclosure of fraud harms the underlying value
of the firm. The analysis shows that an increase in the likelihood of fraud
can actually increase the attractiveness of equity compensation and the
value of the firm. Ironically, while monitoring decreases the likelihood of
fraud, it may indirectly increase the severity of fraud when fraud occurs. (Read
more...)
Improving Internal Auditors' Fraud Risk Assessments: The Benefits of
Brainstorming in Groups
DECEMBER 2007: Recent
financial reporting scandals have prompted actions directed at improving
corporate governance, especially as it relates to fraud prevention and
detection. Internal auditors are now perceived as an important part of the
solution to this breakdown in financial reporting and ethical behavior. We
investigate internal auditors' fraud judgments and seek to increase our
understanding of how these judgments are made. Prior research has questioned
whether brainstorming might improve auditors' fraud judgments and whether
qualitative or quantitative risk assessments are preferred when assessing
the likelihood of fraud. The accounting and psychology research offers mixed
results, and there is no commonly accepted response mode used in practice.
Results from our experiment suggest that when fraud is present, auditors who
brainstorm in groups provide higher fraud risk assessments than both
individual auditors who brainstorm alone and those who do not brainstorm at
all. These brainstorming groups also identify more quality fraud risks than
individual auditors who brainstorm alone. Together these results suggest
that interacting groups provide higher quality fraud judgments than
individual auditors. Results also suggest that auditors who assess risk
qualitatively generally provide higher fraud risk assessments than those
auditors who assess risk quantitatively. However, group interaction appears
to significantly reduce this difference. (Read
more...)
A Field Investigation of Auditors' Use of Brainstorming in the Consideration
of Fraud
FEBRUARY 2007: Audit
standards require auditors to conduct a brainstorming session on each audit
so that engagement team members can discuss the potential for fraud and how
the team might respond to the risk of fraud. Little is known about how this
brainstorming session takes place or how it affects the auditor's
consideration of fraud. This paper reports the results of a field
investigation of audit professionals regarding actual brainstorming sessions
and fraud-related judgments. Our results suggest that, as expected, fraud
risk factors were correlated with fraud risk assessments, but the quality of
the brainstorming session did not uniformly improve these relationships.
However, the overall quality of the brainstorming session positively
moderated the relationships between fraud risk assessments and related audit
testing. Thus, we find auditors to be fairly adept at fraud risk assessment
and that high quality brainstorming improves their response to fraud risk
assessments. (Read
more...)
Novel Criminal Fraud
NOVEMBER 2007: The crime
of fraud has been underdescribed and undertheorized, both as a wrong and as
a legal prohibition. These deficits contribute to contention and uncertainty
over the practice of punishing white-collar crime. This Article provides a
fuller account of criminal fraud, describing fraud law's open-textured,
common-law, and adaptive qualities and explaining how fraud law develops
along its leading edge while limiting violence to the legality principle.
The legal system has a surprising, often overlooked methodology for
resolving whether to treat novel commercial behaviors as frauds: Courts and
enforcers often conduct an ex post examination of whether an actor's mental
state included consciousness of wrongdoing. The Article summarizes this
methodology's history and contemporary applications before moving to the
question of its justification. Among possible normative justifications for
this unusual fault methodology, one fits best and involves fewest
complications: An actor's pursuit of a novel course of conduct (that
involves, as with all fraud, some deception causing or threatening harm), in
the face of actual knowledge that prevailing norms reject that behavior,
renders the actor equivalently blameworthy to an actor who intentionally
pursues a course of conduct that the law has previously described as fraud.
The Article concludes that ex post decisionmakers should continue to apply
this methodology, despite its imperfections; that importing the methodology
into fraud's conduct rules would be possible but also perilous; and that the
methodology identifies the subset of frauds for which criminal sanctions are
justified if one purpose of sanctioning fraud is to assess blame. (Read
more...)
The Effects of Fraud and Going-Concern Risk on Auditors' Assessments of the
Risk of Material Misstatement and Resulting Audit Procedures
JUNE 2007: This study
uses audit file data to analyze the association between the auditors'
preliminary assessments of going-concern and fraud risk and the planning and
performance of the financial statement audit. We analyze the association
between the above risks and the auditor's assessment of the risk of material
misstatement (RMM) within the revenue cycle, and examine whether
going-concern and fraud risk assessments have an effect on the
persuasiveness, timing and extent of audit evidence gathered. Our results
indicate that both fraud risk and going-concern risk are significantly
related to RMM. Our results also indicate that although the effect of fraud
risk is fully mediated by the RMM, moderate going-concern risk remains
significantly related to our proxies for the persuasiveness and timing of
audit evidence, even after controlling for RMM. (Read
more...)
Internal Audit, Alternative Internal Audit Structures, and the Level of
Misappropriation of Assets Fraud
OCTOBER 2007: In recent
years, the importance of good corporate governance has received significant
public and regulatory attention. A crucial part of an entity's corporate
governance is its internal audit function. At the same time, there has been
significant public concern about the level of fraud within organisations.
The purpose of this study is to assess whether organisations with an
internal audit function are more likely to detect and self-report fraud than
those without. (Read
more...)
Beyond Protection: Invigorating Incentives for Sarbanes-Oxley Corporate and
Securities Fraud Whistleblowers
2007: Section 806 of the
Sarbanes-Oxley Act of 2002 (SOX) recognized the importance of private actors
in bringing to light information about corporate financial and accounting
fraud. That section provides some protection for whistleblowers against
retaliation for objecting to, and reporting, violations of the federal
securities laws. While this limited protection is a step in the right
direction, current law does not go far enough to encourage whistleblowers to
risk incurring the adverse social, psychological, and economic consequences
of exposing serious corporate and securities fraud. This Article develops
the bounty model for rewarding SOX whistleblowers, and argues that sound
public policy counsels its adoption and implementation. By giving
whistleblowers a share of the recovery of those damaged by corporate and
financial fraud (a bounty), the law could increase incentives for
whistleblowing. The federal False Claims Act provides a sensible precedent.
(Read
more...)
Professional Skepticism: The Effects of Tone at the Top and Individual
Skepticism on Fraud Risk Assessments and on Identified Audit Procedures
DECEMBER 2007: The
Public Company Accounting Oversight Board (PCAOB), in its recent auditor
inspections, cited a lack of professional skepticism as a serious problem
for auditors and has suggested that the tone at the top set by partners is
critical for auditors' fraud investigations. Using Nelson's (2007) model of
professional skepticism in auditing, this study investigates the effects of
tone at the top (i.e., partner's influence) and auditors' individual
skepticism on fraud risk assessments and audit procedures. Consistent with
predictions of the model, results from our experiment suggest that auditors'
fraud risk assessments are higher under the influence of high tone at the
top than under the influence of low tone at the top, especially when fraud
is present. Also consistent with the model's predictions, we find that an
individual's skepticism influences the choice of appropriate audit
procedures, but interestingly, we find that tone at the top does not.
Extending the model, our results also suggest that tone at the top
influences an auditor's individual skepticism. These results should be
informative to both standard setters and academic researchers as they
suggest that audit partners must set the proper tone at the top in order for
the benefits of professional skepticism to be realized in auditors' fraud
judgments. (Read
more...)
Keeping up with the Joneses: A Model and a Test of Collective Accounting
Fraud
NOVEMBER 2007: This
paper explains the variations in incidence of accounting fraud across
economic settings by putting the behavior and motivation of managers under
the microscope. To safeguard their reputation in the managerial labor
market, managers of firms that perform poorly are prone to fraudulently
inflate earnings if they expect the economy to be strong, since that raises
the likelihood of peers reporting high performance. A realized level of
economic activity, on the other hand, counteracts this tendency on the part
of managers to manage earnings, by reducing the number of firms that
actually perform poorly. We term these two effects the incentive effect and
the need effect, respectively. The existing literature on the incidence of
accounting fraud has not considered the distinct influences of the expected
and the realized levels of economic activity on the behavior of managers
seeking to protect their reputation. (Read
more...)
The Influence of Documentation Specificity and Priming on Auditors' Fraud
Risk Assessments and Evidence Evaluation
FEBRUARY 2008: Audit
documentation is a critical component of the audit process. However, the
Public Company Accounting Oversight Board (PCAOB) recently suggested that
auditors' lack of specific fraud planning documentation has led auditors to
devote insufficient attention to fraud risk factors in subsequent audit
work. In this study, we experimentally investigate how the specificity of
fraud risk documentation during audit planning influences auditors'
subsequent audit work. We also examine whether priming auditors about these
fraud risks before they begin subsequent evidence evaluation affects their
final fraud risk assessments, identification of remaining issues, and
requests for additional evidence. We find that auditors who receive memos
documenting specific fraud risks identified in the planning stage increase
their subsequent fraud risk assessments. However, even though they assess
fraud risk as higher, unprimed auditors who receive specific but incomplete
memos (i.e., memos that do not include all the fraud risks initially
identified in planning) experience output interference and request less
additional audit evidence than auditors who receive either summarized memos
or specific and complete memos. We show that priming helps reduce the
effects of this output interference. (Read
more...)
Restoring Trust After Fraud: Does Corporate Governance Matter?
OCTOBER 2004: In this
study, I examine the association between the credibility of the financial
reporting system and the quality of governance mechanisms. I use a sample of
87 firms identified by the SEC as fraudulently manipulating their financial
statements. Consistent with prior research, results indicate that fraud
firms have poor governance relative to a control sample in the year prior to
fraud detection. Specifically, fraud firms have fewer numbers and
percentages of outside board members, fewer audit committee meetings, fewer
financial experts on the audit committee, a smaller percentage of Big 4
auditing firms, and a higher percentage of CEOs who are also chairmen of the
board of directors. However, the results indicate that fraud firms take
actions to improve their governance and that three years after fraud
detection these firms have governance characteristics similar to the control
firms in terms of the numbers and percentages of outside members on the
board, but exceed the control firms in the number of audit committee
meetings. I also investigate whether the improved governance influences
informed capital market participants. The results indicate that analyst
following and institutional holdings do not increase in fraud firms,
suggesting that credibility was still a problem for these firms. However,
the results also indicate that firms that take actions to improve governance
have superior stock price performance, even after controlling for earnings
performance. This suggests that governance improvements appear to be valued
by investors. (Read
more...)
Do Analysts Anticipate
Accounting Fraud?
APRIL 2007: We examine
whether analysts anticipate the public disclosure of accounting frauds by
studying a sample of companies that have committed fraud as evidenced by the
Security and Exchange Commission (SEC) issuance of an Accounting and
Auditing Enforcement Release (AAER). We use survival analysis to determine
when analysts drop coverage and revise their recommendations down prior to
the public disclosure of fraud. Our analyses indicate some evidence that
analysts anticipate fraud and use different signals to inform investors
about different fraud types. For example, firms that commit larger frauds
are significantly more likely to have analysts drop coverage earlier in the
period preceding the public announcement, but are not significantly more
likely to show downward revisions in recommendations. We also find that
analysts appear to be fooled by fictitious frauds - they are no more likely
to drop coverage or revise down earlier prior to public disclosure for firms
that commit these frauds versus firms that do not commit fictitious frauds.
Finally, our results show that the decision and timing of dropping coverage
is not correlated with revision of forecasts, indicating that analysts
consider different variables for the two decisions. (Read
more...)
Corporate Governance and
Misappropriation
JUNE 2007: This study
examines the occurrence of misappropriation-type fraud within Australian
listed firms and the relation between the incidence of this type of fraud
and a firm's governance strength. We measure governance strength using
factors relating to traditional corporate governance, such as board
composition, CEO duality, and audit committee composition, as well as
factors relating to information technology governance. In our study, we use
actual dollar amount of fraud reported by listed companies responding to the
2004 KPMG Fraud Survey as one of three different misappropriation measures
and publicly available firm-specific data to measure the other variables in
the model. Our study found that where the chief executive officer (CEO) also
holds the position of chairperson of the board of directors, the likelihood
of fraud increases. We also find that the greater the number of independent
directors on the audit committee, the lower the level of fraud. Taken
together, these results are particularly encouraging as they provide support
for regulatory bodies such as the Australian Stock Exchange (ASX) and the
Australian Securities and Investment Commission (ASIC), which place
considerable emphasis on the importance of establishing good corporate
governance practices. The study provides empirical evidence that employing
good corporate governance reduces the risk of the misappropriation of
assets. (Read
more...)
The Cost to Firms of
Cooking the Books
FEBRUARY 2005: We
examine the penalties imposed on all 585 firms that were targeted by SEC
enforcement actions for financial misrepresentation from 1978 - 2002, which
we track through November 15, 2005. The penalties imposed on firms through
the legal system average only $23.5 million per firm. The penalties imposed
by the market, in contrast, are huge. Our point estimate of the reputational
penalty – which we define as the expected loss in the present value of
future cash flows due to lower sales and higher contracting and financing
costs – is over 7.5 times the sum of all penalties imposed through the legal
and regulatory system. For each dollar that a firm misleadingly inflates its
market value, on average, it loses this dollar when its misconduct is
revealed, plus an additional $3.08. Of this additional loss, $0.36 is due to
expected legal penalties and $2.71 is due to lost reputation. In firms that
survive the enforcement process, lost reputation is even greater at $3.83.
In the cross-section, the reputational penalty is positively related to
measures of the firm's reliance on implicit contracts. This evidence belies
a widespread belief that financial misrepresentation is disciplined lightly.
To the contrary, reputation losses impose substantial penalties for cooking
the books. (Read
more...)
The
Consequences to Managers for Financial Misrepresentation
APRIL 2007: We track the
fortunes of all 2,206 individuals identified as responsible parties for all
788 SEC and Department of Justice enforcement actions for financial
misrepresentation from 1978 through September 30, 2006. Fully 93% lose their
jobs by the end of the regulatory enforcement period. A majority explicitly
are fired. The likelihood of ouster increases with the cost of the
misconduct to shareholders and the quality of the firm's governance.
Culpable managers also bear substantial financial losses through
restrictions on their future employment, their shareholdings in the firm,
and SEC fines. A sizeable minority (28%) face criminal charges and
penalties, including jail sentences that average 4.3 years. These results
indicate that the individual perpetrators of financial misconduct face
significant disciplinary action. (Read
more...)
Corporate Governance Post-Enron: Effective Reforms, or Closing the Stable
Door?
MARCH 2007: We examine
Enron's collapse to provide insights as to the efficacy of recent governance
reforms. In doing so, we explore two main issues. First, if recently
mandated governance changes had been in place earlier, would they have
constrained actions by Enron's management? Second, and more generally, which
of the recent governance changes might act to constrain governance failures
going forward? Although many aspects of corporate governance failed at
Enron, the firm's viability ultimately rested on an inherently risky
business strategy, a strategy that the board and others apparently failed to
understand. However, it is not apparent that increasing board independence
would have changed Enron's strategic direction, or prevented the firm's
collapse. From this perspective, many recent reforms, including those
mandating specific board structures likely move firms away from their
optimal governance structure and are tantamount to closing the stable door
after the horse has bolted. We assert that, ceteris paribus, stronger
internal controls coupled with reduced potential for conflicts of interest
on the part of the external auditor might have constrained management's
ability to hide the firm's true financial condition and are likely to
constrain aspects of fraudulent behavior going forward. (Read
more...) |
