Management Fraud
Most security professionals have a great deal of experience dealing with crooked employees. But what happens when the crook is the boss?
In the majority of instances, executives cook the books for the purpose of showing higher profits for their companies. Traditionally, it’s been the duty of the auditors to catch these problems. Unfortunately, critics say they’re not doing a very good job at it.
If you haven’t heard, the recent failure of U.S. energy conglomerate Enron has shaken the American audit profession to its foundations. Congressional committees, frustrated investors, regulators and even the FBI are asking a tough question: “Where were the auditors?”
Security professionals work frequently with auditors in fraud investigations. But since the world’s investors depend heavily on an independent opinion from these well-educated professionals, this question must be addressed.
For the most part, the answer is: They’ve been too busy conducting audits to look for fraud. But for the American investing public, over half of who own stock, that response hasn’t been good enough. As a result, juries have imposed major accounting firms (all having branches in the United Kingdom and around the world) with staggering money damages for their failure to uncover fraud. Still, the problem persists.
In a landmark U.S. Supreme Court case in 1984, the justices re-affirmed that the auditor had an over-arching duty to be the “public watchdog.” But the profession didn’t exactly warm to the notion and has been slow to respond. Indeed, it took the American accounting profession until 1997 to redefine its duties. And believe or not, until then, the audit literature rarely even used the word “fraud,” opting instead for “irregularities.”
Today’s investor can hold the auditors responsible for this situation, but it’s not that they want to be blind to fraud; they are simply following a hundred-year tradition. So to understand where auditors are today, one must look at where they’ve been.
IN THE BEGINNING
Legend has it that the first “auditors” were actually the scribes of ancient Egypt, who were tasked with counting the Pharaoh’s vast holdings – from gold to grain. Even then, it was recognised that not all employees of the realm were equally honest, so the scribes were responsible for catching those who weren’t.
The penalties for failure to detect fraud and theft were severe: At the end of each day, two scribes independently tallied the assets. If their numbers didn’t match precisely, the unfortunate twosome would be put to death.
Although that method of control has been considered tacky by later generations, the fact remained that the primary duty of auditors around the world was to detect and deter fraud. That emphasis started changing around the turn of the 20th century, with the advent of large transnational and international conglomerates.
The American stock market crash of 1929, significantly fuelled by fraud and the lack of uniform accounting standards, ultimately led to the creation of today’s CPA when the U.S. Securities and Exchange Commission, in 1933, required every publicly traded company to be independently audited.
A major task of this fledgling new profession was the establishment of a precise way that companies could keep their books, so that accurate comparisons could be made. This emphasis on the new accounting model would last nearly 50 years. But in the meantime, more hard-pressed businesses started noticing that the auditors were paying more attention to the numbers than what was under them. It became easy to fudge the facts.
Here are examples of just a few cases of how easy it used to be to fool American auditors.
Around the turn of the 20th century, Swedish-born “Match King” Ivar Kreuger inherited a small match factory from his father. Within 30 years, he’d parlayed the business into an international monopoly controlling four-fifths of the entire world’s production of matches. The way he did it was through bribery, intimidation, and blatant fraud.
Indeed, it was Kreuger who created the tale (totally untrue) that it was bad luck to light three cigarettes on one match. According to legend, when the Doughboys of World War I were in the trenches, lighting two cigarettes at night would give the enemy enough time to aim its weapons. And when the match was then passed to the third soldier, “bang!” he was shot dead. An interesting story, but it was concocted by Kreuger for the sole purpose of selling more matches.
Kreuger was just as loose with the facts when it came to his company’s finances. And although the accounting standards at the time were lax, Kreuger took “creative accounting” to a new level (threatening to fire his auditors if they didn’t accept his bogus figures. But a business built on weak and shifting sand can’t stand bad weather; Kreuger was done in by the 1929 stock market crash. And when it became apparent that Kreuger would be vilified, he killed himself.
A similar fate awaited Philip Musica, a three-time loser who changed his name to Dr. F. Donald Coster and acquired the venerable drug company, McKesson and Robbins, during the 1930s.
Musica, a former bootlegger, managed to artificially pump the assets of the drug company by millions of dollars by claiming inventory in Canada that didn’t exist. At the time, there was no requirement for auditors to even confirm the existence of inventory, but this case changed all that. Eventually, Musica was exposed. The morning the police were coming to arrest him, Musica shot himself.
In the 1960s, insurance salesman Stanley Goldblum also acquired a company, Equity Funding, that he would use as a conduit for massive fraud. By the mid-seventies, Goldblum and his lieutenants had managed to add $800 million in phony profits and 65,000 phony policyholders to its books.
The fraud was so massive that nearly 150 people in the company participated in making up phony documents, creating non-existing policyholders (and even “killing off” a few of the phonies to look legitimate), and obscuring the truth from its auditors. A disgruntled former employee revealed the scheme to authorities, Equity Funding went broke, and Stanley Goldblum drew a five-year jail sentence.
By the mid-1980s, there had been a number of high-profile audit failures involving massive fraud. Then, the U.S. savings and loan debacle cost the economy a half a trillion dollars, the majority of which was caused by white-collar crime, and was carried out under the noses of independent auditors.
WHERE WERE THE AUDITORS?
The hue and cry from the public has grown increasingly louder since that time. And now, with Enron, some wonder if the auditing profession (and even the largest and most prestigious accountancy firms in the world) will survive.
The answer would seem to be a qualified “yes.” Just as the ancient Pharaohs depended on their scribes, the integrity of world commerce will forever depend on the fundamental principle of independent oversight. But the accounting profession will not survive in its current form because the public demands otherwise.
A 1999 study by the U.S. Committee of Sponsoring Organisations (COSO) of over 200 financial statement frauds, they concluded that a company’s top brass (the chief executive officer and the chief financial officer) were directly responsible for cooking the books in at least 82% of the cases.
To detect and deter these frauds means that auditors will be required to re-aim their accounting guns. They’ll have to spend more time taking a hard look at the cooks instead of the books. If they are smart, the auditors will involve the considerable talents of corporate security directors this effort.
Since America doesn’t hold the patent on fraud, new accounting regulations are bound to spread, like ripples across the pond, to your neck of the woods, where (who knows?) there may be another Enron waiting in the wings.
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