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18 Jan. 2011 | Comments (0)

With all that has been written and discussed about in the aftermath of the great financial crisis of 2008-2009, there hasn’t been a lot of focus on the detection and deterrence of financial reporting fraud. Granted, fraud might not have been at the center of the crisis like it was in the late 1990s and early 2000s when Enron and WorldCom made headlines for their large accounting scandals. But when you start to look closely at the subprime mortgage mess and the subsequent mortgage securities meltdown, and fair value debate  that followed, it makes more sense to look at what happened through the fraud lens. (If you think about it, probably the only reason the Bernard Madoff Ponzi scheme was revealed was because of the depth of the financial crisis and recession that followed. I remember some pundits comparing the discovery of the Madoff scandal to the large rocks along the coastline that only show up when the tide goes out. Everyone knows they are there but they don’t worry about them because they don’t usually see them.) With that in mind, I found the recent quarterly KPMG Audit Committee Institute Webcast [View archived Webcast] discussion on deterring and detecting fraud to be quite timely and insightful. Michelle J. Hooper, a director who has served on many audit committees and was the co-vice chair of the governing board for the Center for Audit Quality (CAQ), explained the crux of the problem for boards (audit committees especially) when it comes to detecting fraud. The CAQ represents more than 700 public accounting firms. “There is a bias to trust, which lowers the barriers to being skeptical,” Hooper said during the Jan. 11 Webcast. “It can lead you to miss signals or red flags.” Hooper, who serves on the boards of PPG Industries, Warner Music Group,  AstraZenecaPLC, and the National Association of Corporate Directors (NACD), co-presented the CAQ report, Deterring and Detecting Financial Reporting Fraud: A Platform for Action in October with CAQ Executive Director Cynthia M. Fornelli. “Fraud occurs because it is difficult to find,” she told the Webcast audience. “Revenue is a [reason] for committing fraud. For boards, [it is important] to be able to understand how a company makes money. Also, knowing how compensation plans are tied to financial results.” The report stresses the motivators of fraud (the pressure to meet short-term financial goals, the perceived opportunity to get away with such fraud because of weak internal controls and culture, and an individual’s ability to rationalize fraudulent behavior) and key themes for mitigating fraud risk (strong ethical tone at the top, skepticism that leads to professional objectivity, and strong communication among supply chain participants). “What we highlight in the report is that all the parties in the supply chain [management, board of directors/audit committee, internal auditors, external auditors] need to be skeptical,” Fornelli said. “The audit committee, especially, needs to have that questioning mindset.” The 55-page report contains a section devoted to how audit committees should inquire about financial fraud. It lists 10 questions that were developed by the CAQ “to advance the thinking of audit committees around the most likely sources of weakness, with a particular eye for business pressures that may influence accounting judgments or decisions. It is important that audit committees fine tune these questions to fit the organization and recognize that these suggestions are only the starting point for a conversation.” The CAQ makes a point of saying the list of questions is not meant to be a checklist. Ten Questions for Audit Committees 1. What are the potential sources of business influence on the accounting staff’s judgments or determinations? 2. What pressures for performance may potentially affect financial reporting? 3. What about the way the company operates causes concern or stress? 4. What areas of the company’s accounting tend to take up the most time? 5. What kind of input into accounting determinations does non-financial management have? 6. What are the areas of accounting about which you are most worried? 7. What are the areas of recurring disagreement or problems? 8. How does the company use technology to search for an unnatural accounting activity? 9. If a Wall Street Journal article were to appear about the company’s accounting, what would it most likely talk about? 10. If someone wanted to adjust the financial results at headquarters, how would they go about it and would anything stop them? The report also mentions results from some recent fraud surveys that all directors should look at:
  • The Association of Certified Fraud Examiners’ (ACFE) 2010 Report to the Nations on Occupational Fraud and Abuse found that financial statement fraud, while representing less than five percent of the cases of fraud in its report, was by far the most costly, with a median loss of $1.7 million per incident.
  • Fraudulent Financial Reporting: 1998–2007 from the Committee of Sponsoring Organizations of the Treadway Commission (the 2010 COSO Fraud Report), analyzed 347 frauds investigated by the Securities and Exchange Commission (SEC) from 1998 to 2007 and found that the median dollar amount of each instance of fraud had increased three times from the level in a similar 1999 study, from a median of $4.1 million in the 1999 study to $12 million.
  • A 2009 KPMG survey of 204 executives of U.S. companies with annual revenues of $250 million or more found that 65 percent of the respondents considered fraud to be a significant risk to their organizations in the next year, and more than one-third of those identified financial reporting fraud as one of the highest risks.
  • Fifty-six percent of the approximately 2,100 business professionals surveyed during a Deloitte Forensic Center Webcast about reducing fraud risk predicted that more financial statement fraud would be uncovered in 2010 and 2011 as compared to the previous three years. Almost half of those surveyed (46 percent) pointed to the recession as the reason for this increase.
  • About the Author:Gary Larkin

    Gary Larkin

    Gary Larkin is a research associate in the corporate leadership department at The Conference Board in New York. His research focuses on corporate governance, including succession planning, board compo…

    Full Bio | More from Gary Larkin

     

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