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    Fraud Deterrence

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    Here is an article on a fraud deterrence, please read it , give us your opinion and make any comments you may have on its likely significance.


    New Approaches for Fraud Deterrence
    It's time to take a new look at the auditing process.
    by Joseph T. Wells, CFE, CPA
    "If we always do what we've always done,
    we'll always get what we've always gotten."
    - Anonymous
    Call me a skeptic. Maybe it's because I've investigated a couple of thousand fraud cases over a career now
    entering its fourth decade. Perhaps it's because questioning is one of a CPA's most valuable talents. While I
    believe that as a profession we're moving in the right direction, I'm convinced we still have miles to go. The
    auditing profession's current approach to fraud detection-as well-intended as it is-won't have the impact
    the public expects until auditors and their firms are willing to invest in improved fraud deterrence and
    detection skills and resources.
    In my view, even with SAS no. 99, Consideration of Fraud in a Financial Statement Audit, we're still doing
    much of what we've always done. This article should provoke thought and debate among CPAs on how we
    might consider different approaches in the way audits are conducted in order to give the public what it
    really wants: business enterprises with integrity.
    In considering new solutions, it becomes necessary for us to critically examine our current thinking. Over
    the years, I personally have trained thousands of CPAs in antifraud matters. One question that I frequently
    ask is, "How do we prevent fraud?" The answer: "Internal control."
    Oh, really? Under that theory, organizations with adequate controls won't experience fraud. But they do-
    time and time again. Part of the reason is that no controls exist that provide absolute assurance against
    fraud. Those who are sufficiently motivated to override or circumvent them usually can find a way. Don't
    get me wrong: Controls are a vital part of fraud deterrence. However, they need to be considered in a
    larger context.
    Exhibit 1 Exhibit 2
    Source: "Key Crime & Justice Facts at a Glance,"
    U.S. Department of Justice, Office of Justice Programs, Bureau of Justice Statistics.
    Fraud is not an accounting problem; it is a social phenomenon. If you strip economic crime of its
    multitudinous variations, there are but three ways a victim can be unlawfully separated from money: by
    force, stealth or trickery. While the first two are on the wane, the third is not (see exhibits 1, 2 and 3). And
    the reasons have little to do with accounting controls.
    Robbery, theft and other street crimes are the bailiwick of the young and undereducated. According to the
    FBI, these kinds of offenses are at a 30-year low. Why? First, our society-because of baby boomers-is
    aging: There are fewer young people in our population, the net result of which is that there are fewer
    potential offenders. Second, because of mass media, that smaller pool of young people has learned a very
    valuable lesson: The best way to rob a bank is to own one.
    To understand the risk/reward equation, consider just one anecdote from the go-go '90s: Junk-bond king
    Michael Milkin's earnings, largely illegal, amounted to about $1.2 billion. The government fined him $600
    million and he spent 20 months in a federal prison. A thug with a gun holding up a financial institution
    usually will net less than $5,000 and typically will serve at least five years behind bars. Anyone can perform
    the simple arithmetic involved in that crime formula.
    The Confusing Issue of Criminal Justice
    But before you jump to the conclusion that increasing penalties for crime is the answer, consider another
    counterintuitive fact: The United States has some of the harshest criminal penalties in the modern world-
    coupled with the highest crime rates. Criminologists almost universally understand why: Punishment-based
    deterrence simply doesn't work very well. Nearly 75% of incarcerated inmates are rearrested within three
    years of their being released, usually for more serious offenses (see exhibit 4).
    If you are thoroughly confused, you should be. That's because classic criminological theory says there are
    three related factors involved in deterrence: the certainty, swiftness and severity of punishment. Of those
    factors, the first is by far the most important-if punishment is certain and swift, it doesn't need to be
    severe. As a matter of fact, the longer the prison sentence, the more likely it is the miscreant will offend
    Regrettably, under our system of justice, there is nothing certain about being punished. Exacerbating the
    problem, I believe, is the "get tough" mentality that politicians must use to get elected to office. It is one
    thing to pass a law but quite another to appropriate the funds to enforce it. Under Sarbanes-Oxley, the
    criminal penalties for mail fraud were quadrupled, from five to twenty years per offense.
    But there has been no corresponding quadrupling of funds for prosecutors, investigators and prisons. If the
    penalties go up and the money devoted to enforcement stays the same, then the certainty of punishment
    actually goes down. Our prisons are bursting at the seams, so prosecutors and judges are forced to make
    very unattractive choices of who is prosecuted and who isn't. When it comes to making those decisions,
    they almost invariably choose to jail those who commit violent crimes-not the people who rip us off.
    Exhibit 3
    Association of Certified Fraud
    So when a potential fraud offender thinks he or she can commit a
    crime and get away with it, that assessment usually is correct. What
    is society to do, then, about the current wave of fraud that seems to
    have engulfed us?
    First, we need to understand that our problems cannot be solved by
    government intervention. Prosecution of offenders, although
    necessary in a civilized society is akin-as we might say here in Texas
    -to closing the barn door after the horses are gone. Second, we
    must acknowledge the private sector has a responsibility to cure its
    own ills. Third, we must commit the resources necessary to find
    solutions that work.
    Understanding Fraud Prevention
    If you accept the postulate that fraud prevention and internal control
    are not exactly the same-and they aren't-then the accounting
    profession needs to learn more about preventing fraud.
    Factors Affecting
    Occupational Fraud: A
    Partial List
    Financial condition
    of the organization.
    Pressure to show
    profits in the
    Internal accounting
    The state of the
    Integrity level of
    corporate leaders
    and employees.
    Commitment to the
    organization's value
    Personal traits and
    characteristics of
    executives and
    Reward systems for
    ethical behavior.
    culture and
    Peer pressure.
    The perception of
    The swiftness,
    certainty and
    severity of
    Unfortunately, no one has studied this issue in any great detail,
    especially when it comes to occupational fraud. We know some of the
    answers, but not nearly enough. For example, when presented with
    seemingly identical opportunities and motives, why does one person
    or organization turn to fraud and another does not? No one really
    knows. Besides internal control, what factors go into preventing
    fraud? Again, we're short on answers.
    But there is hope. This year, the AICPA and the Association of
    Certified Fraud Examiners established and funded the Institute for
    Fraud Studies (IFS). Other interested organizations and government
    agencies are being invited to participate, too. The IFS will operate
    under the auspices of the University of Texas at Austin, where I teach
    on fraud subjects in the graduate school of business.
    The purpose of the institute is simple: to conduct multidisciplined
    research into the causes of and cures for fraud. It will reach out to
    academics and researchers in a variety of fields such as behavioral
    sciences, the law, accounting and criminal justice. And although the
    IFS has a simple mission, achieving its goals will not be easy. One of
    the first projects will be to help entities find workable solutions to the
    fraudulent financial reporting dilemma.
    A Different Tactic
    One of the most difficult issues facing the profession is that there are
    no auditing procedures that can provide absolute assurance in
    detecting all fraudulent financial reporting. As a result auditors have
    historically attempted to avoid, albeit unsuccessfully, the responsibility
    for fraud detection. In the current environment, the public holds
    expectations of auditors with respect to fraud that simply cannot be
    fulfilled. The auditing profession could be better served by adopting a
    more holistic approach to the deterrence of fraud. This concept,
    called the Model Organizational Fraud Deterrence Program (the
    model), employs a "best practices" approach to fraud prevention.
    Using this model, researchers would identify the factors present in
    organizations-both accounting and otherwise-that affect
    occupational fraud (see "Factors Affecting Occupational Fraud: A
    Partial List"). They then would develop a model deterrence program
    based on those factors. Thereafter, instead of opining that the entity
    is essentially free of material fraud, the auditor would disclose the
    client's degree of compliance to the model.
    Although this is a shift in the way audits are conducted, it has three distinct advantages. First, it would
    move the emphasis away from an unwinnable strategy of detecting fraud to an achievable one-preventing
    it. Second, it would encourage entities to adopt prevention strategies. Third, it could solve the liability
    dilemma that plagues the auditing profession
    But we don't have to wait until we have all the answers in order to do something different. Two ideas are
    worth debating now: the use of antifraud specialists on public audits, and financial transparency for
    Anti-Fraud Specialists on Public Audits
    Accepting that fraud deterrence and accounting are related but distinctly different disciplines, the auditing
    profession could utilize the unique skills of antifraud specialists on public audits. Virtually all of the major
    accounting firms currently employ such specialists. However, they are now being used reactively instead of
    Rather than using their talents exclusively to investigate allegations of fraud once they have been reported,
    antifraud specialists also should be involved during the audit itself to help identify key risk areas, which then
    can be furnished to the auditors for further consideration. Moreover, the mere presence of antifraud
    specialists during audits could have a significant impact on increasing the perception that illegal activity will
    be detected. This is similar to the strategy of reducing crime by putting more cops on the beat. Although
    punishment after the fact doesn't work very well, criminologists have thoroughly documented that more
    vigilance to stop crime before it happens is the most effective deterrent.
    Considering my background, it might be expected that I would
    advocate the use of antifraud experts on audits. But, alas, I can't
    claim credit for the idea. A number of years ago, I videotaped an
    interview with legendary fraudster Barry Minkow while he was
    serving an eight-year sentence in a federal prison in Colorado.
    (Minkow, a high school dropout with no accounting skills, fooled his
    independent auditors in a $100 million financial statement fraud
    scheme.) When I asked him how auditors could cope with his ilk,
    Minkow said: ""I'll tell you what I would do: I'd send in trained
    fraud examiners before the auditors arrive. And I'd tell the client,
    "You know, I really want your business, but I want to make sure
    you're not committing fraud, too. So I'm sending the examiners in
    first. They're going to be looking at everything and asking the tough
    questions.' Would that stop a lot of fraud, or what? It certainly
    would have stopped me."
    Financial Transparency Where It Counts
    From the study of a long list of financial statement frauds,
    beginning with the classic Equity Funding fraud in the 1970s and
    continuing through today's multibillion dollar accounting scandals, a
    distinct pattern has emerged: Corporate managements-executives,
    insiders and board members-have lined their pockets at the
    expense of the shareholders. Their methods vary and are often
    cloaked behind complex transactions not readily apparent to the
    entity's auditors.
    Exhibit 4
    Source: "Reentry Trends in the United States"
    U.S. Department of Justice
    Office of Justice Programs, Bureau of Justice Statistics
    Corporate insiders have a fiduciary duty to act in the best interests of the shareholders. A part of this duty
    should include their financial transparency. Auditors could be given access to any financial information that
    bears on this issue. That would include, but not be limited to, personal tax returns and detailed banking
    records. By having such access, two important objectives could be accomplished. First, it would make it
    more difficult for insiders to conceal ill-gotten gain. Second, financial transparency could be a significant
    and powerful deterrent.
    The ideas contained here are not the complete solution. Even if all of them would be adopted in some form,
    we still would have to recognize that there is no mechanism that could prevent all financial statement fraud.
    Still, traditional accounting approaches have failed so far to solve these difficult problems. But if we do what
    we've always done, we'll get what we've always gotten.
    The Excesses of Executives
    Prosecutors accused Dennis Kozlowski and Mark Swartz of Tyco of stealing another $140 million
    from the company. Their salaries, respectively, were $106 million and $54 million.
    Andrew Fastow, former CFO of Enron, funneled $30 million to himself from off-balance-sheet
    partnerships that he created. Another $17 million was paid to his wife, Lea.
    Federal prosecutors say that Adelphia founder John J. Rigas and two of his sons used the company
    as their "personal piggy bank, purportedly looting over $300 million, which included more than $50
    million in cash advances, money for luxury apartments and a $13 million golf course."
    A jury determined that Mickey Monus, responsible for the $500 million Phar-Mor fraud, embezzled
    at least $10 million to fund the now-defunct World Basketball League.

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    Solution Preview

    The article by Wells clearly said that internal control alone cannot deter fraud. He made it clear in his other article (The Real Secret to Fraud Deterrence published in 2008) that "it is not internal controls per se that deter fraud, but the perception that unlawful conduct will be detected".
    He suggested other techniques like unannounced audit, video camera monitor installations, and other similar overt monitoring techniques.

    I may also add that there is also existing technology on covert software-based video surveillance available commercially today (Eyeline video surveillance, Webcam Monitor, ContaCam, etc).

    We are in an impression that applying the generally accepted accounting principles alone cannot fully detect fraud occurrence. All approaches must be employed.

    The idea of Wells is shared by Causseaux (2007) who agreed that the "fear of detection is the greatest deterrent to fraud".

    Wells' premise was evident during the reign of the Marcoses of the Philippines. Although widely believed, the Marcoses were never found to be committing fraud during their reign. The paper trails were in order. ...

    Solution Summary

    This solution analyzes the article of Joseph T. Wells' articles entitled New Approaches for Fraud Deterrence
    It's time to take a new look at the auditing process. The article showed that fraud cannot be solved by the accounting and auditing process alone. Multifaceted actions must be done.