CHAPTER 3

Role of Forensic Accountants in Corporate Governance and in Detecting and Preventing Fraud

Executive Summary

Forensic accountants work with various corporate governance participants including the board of directors, management, auditors, legal counsel, and law enforcement officials. Corporate governance plays an important role in improving the reliability, integrity, and quality of financial reports and ensuring that they are free from material misstatements whether caused by error or fraud. Financial scandals at the turn of the twenty-first century (e.g., Enron, WorldCom, and Global Crossing, among others) and the 2007 to 2009 global financial crisis suggest existence and persistence of financial statement fraud (FSF) and beg the questions of where corporate gatekeepers were to prevent further occurrences of FSF. Corporate gatekeepers including the board of directors, executive, internal auditors, and external auditors and forensic accountants play an important role in preventing, detecting, and correcting FSF. This chapter describes the roles and responsibilities of forensic accountants in corporate governance and in preventing, discovering, and correcting FSF.

Introduction

Forensic accountants work with many corporate governance participants, federal and state regulators, and law enforcement officials. Financial statement fraud (FSF) incidents are real, and their threats have significantly increased the uncertainty and volatility in the markets, which results in adverse effect on investor confidence worldwide. The FSF incidents prevent investors from receiving meaningful financial information to make sound investment decisions. Effective corporate governance plays an important role in addressing these incidents. Corporate governance has transformed from focusing on the agency theory of ensuring management works for the best interests of shareholders to a compliance process in the post-Sarbanes–Oxley (SOX) Act of 2002 intended to combat FSF to a business strategic imperative in recent years promoting business sustainability, corporate accountability, and social responsibility. The demand for ever-improving and effective corporate governance for business organizations is a global trend in recent years. However, the role of corporate gatekeepers and corporate governance participants in preventing and detecting FSF has not been sufficiently addressed in the literature. The 2010 Committee of Sponsoring Organizations (COSO) report emphasizes the importance of the corporate governance research and its relation to FSF.¹ This chapter presents the role of forensic accountants in corporate governance and in preventing, detecting, and correcting FSF.

Financial Statement Fraud

FSF has become daily press reports challenging the corporate governance and accountability of public companies as well as professional responsibilities and integrity of these companies’ board of directors, senior executives, and auditors. FSF is defined in several authoritative standards² and reports³ as a deliberate misstatement or omission of amounts or disclosures of financial statements to deceive financial statement users, including investors and creditors. The AICPA, AU Section 240, Para. 11, defines FSF “as an intentional act by one or more individuals among management, those charged with governance, employees, or third parties, involving the use of deception that results in a misstatement in financial statements that are the subject of an audit.”⁴ Alleged high-profile incidents of FSF, committed by large companies such as Enron, Global Crossing, Waste Management, Sunbeam, Lucent, MicroStrategy, KnowledgeWare, Raytheon, Cendant, and Rite Aid, to name just a few, have received considerable attention of the investing public, regulators, and the accounting profession. FSF has cost investors more than $100 billion during the wave of financial scandals at the turn of the twenty-first century.⁵

FSF has been one of the most dominating news cycles in the past several decades from Enron and WorldCom in 2001 to Madoff, Stanford Financials, and Satyam recently. There have been many FSF cases that have undermined the integrity and reliability of financial reports and have contributed to significant damages to reputation and economic losses. FSF has eroded investor confidence in the quality, usefulness, and reliability of financial statements. The collapse of Enron and WorldCom, among others caused by FSF, resulted in erosion of investor confidence that encouraged Congress to respond by passing the SOX Act of 2002.⁶ The existence and persistence of FSF continues to contribute to the financial uncertainty and market volatility, which prevent global investors from receiving meaningful financial information to make sound investment decisions.

Incidents of FSF have continued to increase even after the passage of the SOX Act of July 2002, which was intended to combat financial fraud.⁷ The 2010 Committee of Sponsoring Organizations of the Treadway Commission (COSO) report found 347 cases of FSF from 1998 to 2007 compared with 294 fraud incidents from 1987 to 1997 with an increase of 18 percent.^8,9 The COSO report indicates that key areas in which fraud occurs and the causes of fraud. Along with this increase in total cases, the dollar amount of fraud also increased across the spectrum. Misappropriation was 120 billion in 300 cases (mean of 300 million per fraudulent event) in the 2010 study compared with the 1987 to 1998 study where the mean was $25 million. These events occurred when the average revenues were 100 million and 16 million, respectively.¹⁰

The COSO report indicates that top management teams (e.g., chief executive officer [CEO], chief financial officer [CFO], treasurer, controller, and other top executives) were involved in 89 percent of reported cases from 1998 to 2007 compared with 83 percent in the 1987 to 1997 study. Of the top executives that were sent to trial, 20 percent were sent to jail and 60 percent were found guilty. As a result of these outcomes, it was discovered that the most common means of fraud were revenue recognition and overstatement of financial accounts, particularly assets and capitalizations. These frauds caused a decline in stock prices, loss in public trust, and often lead companies to file for bankruptcy.¹¹ When the company is not effective in generating sustainable performance, the management is under more pressure to manage earnings. Opportunities to engage in FSF are higher when the company is not doing well financially and unable to invest in effective corporate governance and internal controls. Emerging corporate governance reforms, securities laws, and best practices are intended to identify and minimize potential conflicts of interest, incentives, and opportunities to engage in FSF.

FSF occurs for a wide variety of reasons, including when motives combine with opportunity. Corporations’ strategies to meet or exceed analysts’ earnings forecasts pressure the management to achieve earnings targets. Managers are motivated or, in most cases, rewarded when their bonuses are tied to reported earnings, which can lead managers to choose accounting principles that may result in the misrepresentation of earnings. Companies are more likely to engage in FSF when quality and quantity of earnings are deteriorating, management has all incentives and pressures to manipulate earnings, opportunity to engage in FSF exist, and management can rationalize that the benefits outweigh the associated costs calculated using the probability and consequences of detection.

Economic incentives are common in FSF, even though other types of incentives such as psychotic, egocentric, or ideological motives may play a role. Pressure on management to meet analysts’ earnings forecast may force management to manipulate earnings. Opportunities to engage in FSF are higher when the company is not doing well financially and unable to invest in effective corporate governance and internal controls in designing and maintaining proper antifraud policies and practices. Emerging corporate governance reforms, securities laws, and best practices are intended to identify and minimize potential conflicts of interest, incentives, and opportunities to engage in FSF. Management evaluates the opportunity for earnings manipulation and the benefit of earnings management in terms of the positive effect it will have on the company’s stock price against the possible cost of consequences of engaging in FSF and the probability of detection, prosecution, and sanction.

Some of the prevailing reasons for the occurrences of FSFs are as follows:

Forensic accountants’ responsibilities concerning FSF are as follows:

Forensic accountants by virtue of their independence, expertise, and knowledge are expected to discover FSF. However, they are several reasons why forensic accountants may fail to discover FSF. Among those reasons are:

More specifically, forensic accountants may fail to discover FSF for the following reasons:

Enron fraud case is presented to highlight an important role that corporate gatekeepers are playing in preventing and detecting fraud. Enron Corporation was once (2001) the seventh largest public company in the United States, and in the next year was the largest company to ever declare bankruptcy in U.S. history. In less than a year, Enron went from being considered one of the most innovative companies of the twentieth century to being the most corrupted and fraudulent company. FSF committed by Enron Corporation is estimated to cause a loss of about $70 billion in market capitalization to investors, creditors, employees, and pensioners. Its investors lost billions of dollars, directors paid penalties, executives were indicted and subsequently convicted, employees lost their job and pension investment, the auditor (Andersen) was demised, and regulators and standard setters were blamed for not providing early warning signals of potential business failure. Enron is one example of vast FSF cases that undermine the integrity of financial reporting process and the safety, efficiency, and soundness of the financial markets.

FSF has become daily press reports challenging the corporate responsibility, accountability, and integrity of major companies as their executives (CEO and CFO) are being accused of cooking the books. Occurrences of FSF by high-profile companies have raised concerns about the integrity, transparency, and reliability of the financial reporting process and have challenged the role of corporate governance in preventing and detecting FSF. Exhibit 3.1 presents a list of high-profile cases of FSF that have proved to be detrimental to sustainability of public companies and caused risks to the efficiency and safety of the financial markets. Exhibit 3.1 reveals that common themes of reported FSF are as follows:

There are many reasons why FSF may occur. These reasons fall under the three categories—conditions, corporate structure, and choice (3Cs)¹²—which explain motivations, opportunities, and rationalizations for the commission of FSF. Conditions provide motivations and opportunities for perpetrators to engage in FSF. FSF will occur when the benefits to perpetrate outweigh the associated costs. Pressures on corporations to meet analysts’ earnings forecasts play an important role in the commission of FSF. Management evaluates the benefits of overstating earnings and assets and/or understating liabilities and expenses in terms of a positive effect on the company’s stock price against the costs and consequences of committing FSF and the probability of detection, prosecution, and sanction.

Exhibit 3.2 presents several FSF studies and cases that highlight the existence and persistence of fraud cases. Corporate structure can create an environment that increases the likelihood of the occurrence of FSF. Given that FSF is typically committed by the top management team (i.e., more than 80 percent committed by top executives, CEOs, and CFOs),¹³ one would expect incidences to occur most in an environment characterized by irresponsible and ineffective corporate governance. The characteristics and attributes of the corporate governance structure, most likely to be associated with FSF, are aggressiveness, arrogance, cohesiveness, loyalty, trust, control ineffectiveness, and gamesmanship. Aggressiveness and arrogance can be signified by the company’s attitude and motivations toward being the world’s leading company or exceeding analysts’ earnings expectations by cooking the books. Cohesiveness, gamesmanship, and loyalty attributes create an environment that increases the likelihood of cooking the books and subsequent cover-up attempts and decreases the probability of whistle-blowing. Trust and control ineffectiveness can cause monitoring mechanisms (e.g., oversight functions, audit functions, and internal control structure) to be less effective in preventing and detecting fraud.

FSF has been a contributing factor to the 2007 to 2009 global financial crisis, resulting in a global economic meltdown, and has threatened the efficiency, liquidity, and safety of both debt and capital markets. These financial crises have substantially increased volatility and uncertainty in financial markets and have adversely affected investor confidence and public trust worldwide. Choice provides management with the flexibility to use its discretion to either choose ethical business strategies of continuous improvements of both the quality and quantity of earnings, or to engage in illegitimate earnings management schemes of cooking the books to show earnings stability or earnings growth. Management may be motivated to engage in FSF when (1) its personal wealth is closely associated with the company’s performance through profit sharing, stock-based compensation plans, and other bonuses; (2) management is willing to take personal risks for corporate benefit (e.g., risk of indictment and civil or criminal penalties); (3) opportunities for the commission of FSF are present; (4) there is a substantial internal and external pressures to either create or maximize shareholder value; and (5) the probability of FSF being detected is perceived by management to be very low.

FSF may involve the following schemes¹⁴:

The Association of Certified Fraud Examiners (ACFE) estimates that business organizations lose about 5 percent of their revenues to fraud each year, which can exceed $3.5 trillion worldwide.¹⁵ This is just the direct economic losses resulted from FSF. Other fraud costs are legal costs, increased insurance costs, loss of productivity, adverse impacts on employees’ morale, customers’ goodwill, suppliers’ trust, and negative stock market reactions. An important indirect cost of FSF is the loss of productivity owing to dismissal of the fraudsters and their replacements. Although these indirect costs cannot possibly be estimated, these costs are typically more than the direct money and assets losses and they should be taken into consideration when assessing the consequences of FSF. Exhibit 3.3 shows a list of global FSF, their description, consequences and accountability. These FSF cases underscore the detrimental effects of global fraud and individual perpetrators and their accountability.

Corporate Governance and Fraud

Corporate governance has evolved as a central issue within regulators and public companies in the wake of recent global financial crisis. Companies have recently undergone a series of corporate governance reforms aimed at improving the effectiveness of their governance, internal controls, and financial reports. Effective corporate governance promotes accountability, improves the reliability and quality of financial information, and prevents financial reporting fraud. Poor corporate governance adversely affects the company’s potential, performance, financial reports, and accountability and can pave the way for business failure and financial reporting fraud. Corporate governance measures of the oversight function assumed by the board of directors, managerial function delegated to management, internal audit function conducted by internal auditors, and external audit function performed by external auditors are vital to the quality of financial information. An increasing number of alleged FSF and earnings restatements by high-profile companies has caused lawmakers (e.g., Congress), regulators (e.g., Securities and Exchange Commission [SEC]), and the accounting profession (e.g., AICPA and Institute of Internal Auditors [IIA]) to address the role of corporate governance as well as the integrity and quality of the financial reporting process and audit efficacy.

The Enron debacle, caused by the alleged commission of FSF, has raised concerns regarding a lack of vigilant oversight function of its board of directors and audit committee in effectively overseeing Enron’s financial reporting process and audit functions. Corporate governance is viewed as interactions among participants in managerial functions (e.g., management and top executives), oversight functions (e.g., the board of directors and the audit committee), audit functions (e.g., internal auditors and external auditors), monitoring functions (e.g., lawmakers, regulators, SEC, and standard setters), and user functions (e.g., investors, creditors, and employees).¹⁶ Corporate governance framework determines the organization’s corporate governance culture, structure, mechanisms, and compliance, as well as the roles and responsibilities of all corporate governance participants. The framework also determines how organizations fulfill their roles and responsibilities, as well as being held accountable through corporate reporting and assurance.

Corporate governance has garnered considerable attention in the wake of the 2007 to 2009 global financial crisis and is now emerging as a central issue for regulators and public companies. Large public companies have recently undergone a series of regulatory reforms resulting from legislation imposed by the U.S. Congress (e.g., SOX Act of 2002 and Dodd-Frank Act of 2010), new regulations from the SEC, listing standards of national stock exchanges, and best practices of investor activism. Corporate governance measures are designed to protect shareholders and other stakeholders’ interests by limiting opportunistic behavior of managers who control their interests. Corporate governance measures including proper antifraud policies and practices are intended to protect investors from receiving fraudulent financial information.

One of the key responsibilities of corporate governance participants is to ensure the quality, integrity, reliability, and transparency of financial statements and provide a reasonable assurance that they are free from any misstatements caused by errors or fraud. Proper antifraud policies and practices improve the effectiveness of corporate governance and thus reliability of financial statements.

Corporate governance reforms in the past two decades are intended to improve the effectiveness of corporate governance in preventing, deterring, detecting, and correcting FSF. Corporate governance is a process affected by legislations, legal, regulatory, contractual and market-based mechanisms, measures, and reforms, as well as best practices to create sustainable shareholder value while protecting the interests of other shareholders.¹⁷ This definition implies that there is a dispersed ownership structure, and thus the role of corporate governance measures is to protect shareholders and other stakeholders’ interests by limiting opportunistic behavior and self-dealing practices of management who controls their interests. Under the U.S. dispersed ownership system, it is highly possible that management has incentives and opportunities to engage in short-term earnings management and quarterly FSF.

Corporate governance is about leadership and accountability for (1) setting a tone at the top promoting integrity and competency throughout the organization; (2) improving efficiency and effectiveness of operations to compete in the global markets; and (3) producing accurate, complete, and transparent financial and nonfinancial information. Thus, the main responsibilities of corporate governance participants and corporate gatekeepers are to ensure the quality, integrity, reliability, and transparency of financial statements in providing a reasonable assurance that they are free from material misstatements caused by errors or fraud.

Antifraud Policies and Practices

Corporate governance and its participants play an important role in designing, maintaining and implementing adequate and effective antifraud policies. These policies are intended to to protect investors from receiving fraudulent financial information. Thus, effective corporate governance in strengthening antifraud policies and practices promotes accountability, improves the reliability and quality of financial information, enhances the integrity and efficiency of the capital market, and improves investor confidence. Poor corporate governance adversely affects the company’s potential, performance, financial reports, and accountability and can pave the way for business failure, fraudulent public financial information, inefficiency in capital markets, and loss of investor confidence. Proper antifraud policies and practices improve the effectiveness of corporate governance and thus reliability of financial statements. As described in Exhibit 3.4, antifraud policies and practices can prevent and detect FSF. These antifraud policies and practices are classified into preventing, detecting, and correcting corporate governance measures influenced by all corporate gatekeepers including the board of directors and the audit committee, management, internal auditors, and external auditors. The board of directors as representative of all stakeholders (investors, employees, society) has a fiduciary duty to protect their interests and ensure that their decisions (investment, employment) are not affected by misleading financial information.

The effectiveness of the board oversight function depends on directors’ independence, due process, authority, resources, composition, qualifications, and accountability. Senior executives consisting of the CEO and CFO are responsible for managing the company and its resources and operations, as well as certifying the accuracy and completeness of financial reports. The effectiveness of the managerial function depends on the alignment of management’s interests with those of shareholders and ensuring reliability of financial reports. Internal auditors are regarded as the first defence against fraudulent activities, providing both assurance and consulting services to the company in the areas of operational efficiency, risk management, internal controls, financial reporting, antifraud, and governance processes. External auditors are also expected to discover and report FSF. Exhibit 3.4 presents strategies, policies, and procedures in preventing, detecting, and correcting FSF.

Several strategies can be established to prevent, detect, and correct FSF. The following are the examples of these strategies: (1) establishment of a responsible corporate governance, vigilant board of directors and audit committee, diligent management, and adequate and effective internal audit functions; (2) utilization of alert, skeptical external audit function, responsible legal counsel, adequate and effective internal control structure, and external regulatory procedures; and (3) implementation of appropriate corporate strategies for correction of the committed FSF, elimination of the probability of its future occurrences, and restore confidence in the financial reporting process. FSF occurs when one strategy or a combination of these strategies are relaxed because of self-interest, lack of due diligence, pressure, over-reliance, or lack of dedication. The opportunity of occurrence of FSF is significantly increased when these strategies are inadequate and ineffective.

High-profile FSF incidents in recent years have raised serious concerns about the following: (1) the role of corporate governance participants and corporate gatekeepers including the board of directors and audit committees, executives, and auditors in preventing and detecting FSF; (2) integrity, competency, and ethical values of corporate gatekeepers; and (3) ineffectiveness of internal and external audit functions in detecting and reporting FSF. Incidents of FSF are harmful to companies and their gatekeepers in many ways including the following:

Prevention and detection of FSF is the responsibility of all corporate governance participants and those involved with financial statements’ supply chain. These individuals are members of the board of directors including the audit committees, management, internal auditors, external auditors, the SEC, and users of financial reports.

The existence of responsible and effective corporate governance, consisting of a vigilant and active board of directors, an effective audit committee, and adequate and effective internal audit function, discovers the intended FSF and prevents its occurrence. When FSF is prevented at this stage, the financial information will not be misleading. However, ineffective and irresponsible corporate governance, along with the gamesmanship attitude of corporate governance, would fail to prevent the deliberate FSF perpetrated by management. Management may operate in its own self-interests rather than the interests of stakeholders. Lack of adequate and effective corporate governance (e.g., internal control) may create opportunities for management to appoint the board of directors, auditors, and the audit committee and offer the monetary incentive of their continued employment. This potential for moral hazard causes a fiduciary conflict of interest in the sense that management can bend the board of directors, the audit committee, and auditors to its will. Management may act honestly but incompetently in managing the corporate affairs. This causes management to be ineffective in creating shareholder value. In this case, the board of directors should exercise its oversight authority of replacing the current management team.

The board of directors and its representative audit committee should oversee the following: (1) the integrity, quality, transparency, and reliability of the financial reporting process; (2) the adequacy and effectiveness of internal control structure in preventing, detecting, and correcting material misstatements in the financial statements; and (3) effectiveness, efficacy, and objectivity of audit functions. Enron, WorldCom, and Global Crossing debacles indicate that many boards of directors are not good caretakers. Boards are theoretically elected to act as the shareholders’ eyes and ears to ensure creation of shareholder value.

Boards are elected to hire executives (e.g., top management team) and drive their performance through the carrot (higher executive compensation) and the stick (compensation cuts and termination). However, lack of due diligence by the board of directors creates opportunities for management to engage in FSF. The board of directors and audit committee of Enron are coming under sharp criticism for allowing the use of special-purpose entities (SPEs) to overstate earnings and understate liabilities. Some directors and audit committee members are even being accused of “insider trading” for making misleading statements about the company’s prospects and selling more than $1 billion worth of stock during the last 3 years before the Enron crisis.

A significant portion of Enron’s success was built on an elaborate foundation of smoke and mirrors with much of its success proved to be scam and resulted from questionable business practices. In 15 years, Enron grew from inception to America’s seventh largest corporation, employing more than 21,000 persons in more than 40 countries. Although the fall of Enron was because of a failed business model and spin-off ventures in water, international energy brokerage, and broadband communications, Enron’s demise began when investors became aware of off-balance sheet partnerships and SPEs that hid billions of dollars of losses. One of the major techniques to facilitate the deception was Enron’s executives’ use of more than 1,500 SPEs and partnerships to achieve off-balance sheet treatment of assets and liabilities. Some of these transactions essentially involved Enron receiving borrowed funds that were made to look like revenues, without recording liabilities on the company’s balance sheet.

In many cases, Enron personnel held personal stakes in these related-party entities, reaping profits in addition to their Enron compensation. For example, Enron admitted that Andrew Fastow, Enron’s CFO, earned more than $30 million from his positions in the partnerships. In 2001, Enron found itself in real trouble when, simultaneously, the business deals underlying these transactions went sour and its stock price plummeted. Debt holders began to recall the loans owing to Enron’s diminished stock price, and the company found its business sustainability and accounting positions increasingly problematic to maintain. Public disclosure of diminishing liquidity, questionable management decisions, and unsustainable business practices and performance destroyed the public trust and investor confidence that Enron had established within the business community. This caused hundreds of trading partners, clients, and suppliers to suspend doing business with the company, its shareholders selling their shares, and bondholders recall their loans, which ultimately lead to its downfall.

Corporate Gatekeepers Role in FSF

The existence of responsible and effective corporate governance, consisting of a vigilant and active board of directors, an effective audit committee, responsible management, proper audits and adequate and effective internal audit function can prevent, detect and correct FSF. When FSF is prevented at this stage, the financial information will not be misleading. However, ineffective and irresponsible corporate governance, along with the gamesmanship attitude of corporate governance, would fail to prevent the deliberate FSF perpetrated by management. Management may operate in its own self-interests rather than the interests of stakeholders. Results of a survey indicates that the majority of the respondents (about 82 percent) believe that future demand for and interest in corporate governance will increase, supporting that current initiatives toward promoting corporate governance by policymakers, regulators, businesses, and educators worldwide.¹⁹ This survey also shows that (1) financial scandals and crisis galvanize more demand for and interest in effective corporate governance; and (2) corporate governance participants and thus corporate gatekeepers should ensure the quality, integrity, reliability, and transparency of financial statements; (3) effective corporate governance promotes accountability and improves the reliability and quality of financial information; and (4) effective corporate governance reduces FSF.²⁰

Antifraud Role of the Board of Directors

A vigilant board of directors that proactively oversees strategic decisions, management’s plans, decisions, and actions as well as compliance with all applicable laws, rules, regulations, standards, and best practices can be very effective in achieving good governance and protecting stakeholders from receiving misleading and fraudulent financial reports. The primary responsibility of the board of directors is the appointment of the CEO and approval of the appointment of other senior executives (top management team) to run the company for the benefit of its shareholders. Boards of directors have experienced unprecedented challenges and opportunities in the post-SOX era, and some boards still struggle to find the proper balance between engaging in the strategic decisions of overseeing managerial decisions and actions and ensuring compliance with applicable laws, rules, regulations, and standards and preventing financial scandals and crises. In the aftermath of the global financial crisis of 2007 to 2009, it is expected that the boards of directors engage more proactively in the oversight function, especially in an ever-increasingly complex business environment, the governance practices, strategic priorities in dealing with global economic and political uncertainties, financial crises, fraud, and the potential risk of cybersecurity.

The boards of directors are primarily responsible to protect investor interests and ensure that they are not receiving misleading financial information that may affect their investment decisions. A survey suggests that the board of directors can effectively fulfill its fiduciary duties of ensuring published financial statements are free from material misstatements caused by errors and fraud by (1) supervising the implementation of antifraud measures, including deterrence, prevention, and detection; (2) setting a tone at the top promoting ethical and competent behavior throughout the organization; (3) assessing management performance and compensation and its relevance to fraud risk assessment; (4) overseeing the audit performed by independent auditors in discovering material financial misstatements; (5) overseeing proper design and effective implementation of antifraud policies and procedures; (6) overseeing the financial reporting and internal control processes; (7) considering feedback received from the independent auditors; and (8) including at least one financial expert in the audit committee to improve financial expertise of the committee in overseeing financial reports, internal controls, and the audit process.²¹

Improving corporate governance and enhancing reliability of financial statements are receiving significant attentions from lawmakers, regulators, the financial community, standard-setting bodies, and the accounting profession. This well-deserved attention stems from a variety of reasons, including widely publicized business failures, high-profile alleged FSF committed by big corporations, lack of vigilant oversight functions by the board of directors and audit committee, irresponsible management, inadequate governance structure, and ineffective audit functions. The increasing interest in and demand for more responsible and effective corporate governance have provided a unique and timely opportunity for the audit committee to improve its oversight function.

The corporate culture of integrity, competency, resilience, responsiveness, transparency, accountability, and value-adding philosophy can play an important role in the continuous improvements and sustainable performance and business success. Because directors’ fiduciary duty and loyalty are to the shareholders, directors should set the tone at the top in promoting a healthy corporate culture and reliable financial reports free of material errors, irregularities, and fraud to protect the interests of shareholders and create shared value for all stakeholders. The main failure of Enron’s directors and officers (D&O) was violation of fiduciary duty of protecting interests of shareholders and other stakeholders (e.g., employees, suppliers, customers, government, and society). During the first week of January 2001, the revelry and celebration was an Enron event when Kenneth L. Lay, longtime chairman and chief executive, said the company would take on a new mission: Enron would become “the world’s greatest company.”

The Enron board “waived” the company’s own ethics code requirements to allow the company’s officers to serve as general partner for the partnerships used as a conduit for much of its business. Directors ignored the duty of good faith and full disclosure. There is no evidence that when Enron’s CEO told the employees that the stock would probably rise that he also disclosed that he was selling stock. Moreover, the employees would not have learned of the stock sale within days or weeks, as is ordinarily the case. Only the investigation surrounding Enron’s bankruptcy enabled shareholders to learn of the CEO stock sell-off before February 14, 2002, which is when the sell-off would otherwise have been disclosed. Essentially, the concern with a fiduciary’s appearances is on the basis of the fiduciary’s implicit role in assuring that the company will observe the spirit as well as the letter of the law. The fiduciary duty is to protect stakeholders not to violate through the waiver of the company’s own ethical code.

Directors are usually subject to liability exposure under state and federal law. State law imposes on directors the fiduciary duties of obedience, loyalty, good faith, and due care. Breaches of these mandatory duties can result in litigations against directors where the court determines the nature and extent of directors’ liability. It is very rare that outside directors serving on board committees come under scrutiny and investigations by federal authorities for their decisions on the board. However, the three outside directors of Mercury Interactive Corp. who served on both its compensation and audit committees and signed off on the alleged illegal and intentional backdated options are under investigation by the SEC.²² The SEC, in June 2006, advised these directors that it was considering filing a civil complaint against them regarding their involvement and approval of manipulated stock options grants.²³ It would be the first time that all the members of the compensation and audit committees could face civil charges, if the SEC decides to take further action against these directors for conduct that did not even happen in high-profile scandals of Enron and WorldCom.²⁴

In the WorldCom settlement case, 12 of the company’s outside directors agreed to pay $24.75 million from their personal funds; in the Enron case, 10 of the outside directors agreed to pay $13 million in personal contributions. Agreements reached for personal contributions in these two cases may have profound and unprecedented implications for and effects on the determination of future directors’ personal liability. Many have argued that the existing securities litigation trend will have a chilling effect on recruiting outside directors and maintaining existing directors who face the exposure of losing personal assets.²⁵ The consensus is that in these two cases, the board of directors in general and outside directors, failed to effectively discharge their oversight responsibilities and acquiesced entirely to the company’s CEO and thus did not prevent corporate wrongdoings. The signal sent by Enron, WorldCom, and subsequent personal contributions is that as the guardians for protecting investors’ interests, directors will be held accountable and personally liable when they allow fraud and violations of securities laws to be committed by their company’s management.

The Enron and WorldCom cases were rare situations of outside directors suffering liability. In both companies:

Antifraud Role of Management

The board of directors of public companies as representative of shareholders appoints the management team heading by the CEO and other members, including the CFO, controller, treasurer, and other officers to run the company. Management, under the oversight direction of the board of directors, is primarily responsible for all managerial functions, including the development and execution of corporate strategies, safeguarding resources, ensuring effective and efficient operations, promoting reliability of financial reports, and ensuring compliance with all applicable laws, rules, regulations, standards, and best practices to create long-term and sustainable shareholder value.

Management consisting of the CEO and CFO is responsible for managing the company for the best benefit of shareholders and ensuring they receive accurate, complete, and reliable financial information in making investment and voting decisions. The effective discharge of this responsibility requires management to produce reliable, transparent, and accurate financial statements free of material misstatements caused by errors and fraud. Results of a survey show that antifraud policies, procedures, and practices of management should ensure the following: (1) the adoption of a proactive approach in addressing fraud deterrence, prevention, and detection; (2) the design, implementation, and maintenance of sound financial and effective internal control systems; (3) preparation of reliable financial statements free of material misstatements caused by errors and fraud; and (4) design and implementation of effective antifraud policies and procedures.²⁷

Compliance with both the spirit and the requirements of applicable rules, regulations, and laws, including legal, regulatory, and tax and accounting rules, is one of the primary responsibilities of management. The focus of the investing community and the financial markets will continue to be on a public company’s financial performance; however, recently companies’ social responsibility performance has also started to receive attention. Laws, rules, and regulations have recently increased significantly in response to the emerging global competition, which has reshaped financial and capital markets structure worldwide to provide adequate protections for global investors. The globalization of capital markets and the demand for investor protection in response to financial scandals worldwide (e.g., Enron, WorldCom, Parmalat, and Ahold) also require consistency and uniformity in regulatory reforms and corporate governance practices, and thus proper compliance with them.

The global competitive nature of U.S. capital markets is driven by tougher regulatory reforms in protecting investors. According to the Corporate Fraud Task Force’s 2008 Report to the President, the Department of Justice charged 34 defendants during its 4-year investigation of the Enron collapse. Twenty-six of the thirty-four were former Enron employees. The CEO, Jeffrey Skilling, and the CFO, Andrew Fastow, were among those receiving prison sentences. Kenneth Lay, Chairman of the Board, was found guilty but died while awaiting an appeal opportunity. Lea Fastow, wife of Andrew Fastow, was sentenced to 1 year in prison for her role in filing tax returns that did not include some of the ill-gotten gains from her husband’s schemes.

Antifraud Role of Internal Auditors

Internal auditors are the first defence against fraudulent financial activities by assisting management to achieve operational efficiency and effectiveness, proper risk management, internal controls evaluation, financial reporting certifications, and antifraud and governance policies and procedures. Results of a survey suggest that internal auditors should assist management in (1) developing and maintaining sufficient skills to identify the indicators of fraud; (2) implementing and monitoring the established antifraud policies and procedures; (3) adopting proactive approach in detecting employees’ fraud and FSF; (4) using a risk-based audit methodology in assessing fraud risk; and (5) planning audits in accordance with industry standards, and where applicable, obtain audit committee (or the board of directors) approval.²⁸

Internal auditors are integral parts of corporate governance and their expertise in internal control is on the front line in preventing, detecting, and correcting FSF. Internal auditors are viewed as a first-line defence against fraud because of their knowledge and understanding of internal control structure and the business environment. Internal auditors’ responsibilities for detecting, investigating, and reporting FSF are stated in their standards SIAS No. 3.²⁹ Recently, the IIA, in its position paper presented to the U.S. Congress, states “Internal auditors, the board of directors, senior management, and external auditors are the cornerstones of the foundation on which effective corporate governance must be built.”³⁰ The IIA also recognizes that internal auditors are an active participant in corporate governance, yet an independent observer of that process.

Internal auditors play an important role in ensuring a responsible corporate governance and a reliable financial reporting process and an effective system of internal controls by assisting their organization in (1) improving the quality, integrity, reliability, and transparency of financial information; (2) preventing, detecting, and correcting FSF; (3) assisting management to fulfill its financial reporting responsibilities; (4) ensuring the adequacy and effectiveness of internal control structure; and (5) cooperating with outside auditors to improve audit efficacy. Andersen conducted both the external and internal audits of the bankrupt Enron, which possibly created conflicts of interest that ultimately impaired Andersen’s objectivity and integrity.

Internal auditors should identify red flags that signal the possibility of fraud, investigate symptoms of fraud, and report the detected fraud or its possibility of occurrence to appropriate authorities within their organization, such as top executives, the audit committee, and the board of directors. The following suggestions can enhance the active role of internal auditors in the financial reporting process, and thus, their role in preventing, detecting, and correcting FSF³¹:

A close working relationship between the audit committee and internal auditors can improve the effectiveness of corporate governance. First, the independence and objectivity of internal auditors can be strengthened when they report their findings and opinions directly to the audit committee. Second, the prestige and status of internal auditors can be enhanced when they work with management at all levels while being accountable to the audit committees. Third, internal auditors can be of a significant assistance to audit committees to effectively fulfill their oversight duties in functions such as financial reporting, internal controls, risk management, external audit, whistle-blowing, ethics, and taxes.

Internal auditors’ reports should (1) disclose all relevant information about the effectiveness of the organization’s corporate governance; (2) focus on its sustainability performance in all areas of economic and financial, social, ethical, governance, and environmental activities; (3) provide transparent financial and nonfinancial information on key performance indicators (KPIs) and their impacts on all stakeholders; and (4) assess the organization’s responsiveness to the needs of all of its stakeholders.

Antifraud Role of External Auditors

FSF has been and continues to be the focus of the auditing profession. During the 1890s, external auditors viewed the detection of fraud, in general, and FSF as the primary purpose of the financial audit. The auditing profession had moved from acceptance of fraud detection as a primary purpose to the expression of an opinion on fair presentation of financial statements during the twentieth century. The accounting profession has initially addressed the external auditor’s responsibility for FSF detection in SAS No. 82 and SAS No. 99 titled Consideration of Fraud in a Financial Statement Audit.³² SAS No. 82, which is superseded by SAS No. 99, required the independent auditor to consider a broad range of fraud risk factors in assessing the risk of occurrences of FSF and to use this assessment in audit planning to detect fraud.

The Auditing Standards Board (ASB) of the AICPA, by issuing SAS No. 99, attempts to clarify, but not to expand, the auditor’s responsibility to detect and report FSF. SAS No. 99 states “The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether caused by error or fraud (emphasis added).”³³ SAS No. 99 makes it clear that the auditor’s responsibility for detecting fraud is framed by the concepts of reasonable, but not absolute, assurance and materiality and subject to cost/benefit decisions inherent in the audit process. However, although auditors are not expected to detect all employees’ frauds, the public expects auditors to detect material FSF perpetrated by management with the purpose of misleading investors and creditors. Independent auditors provide reasonable assurance that financial statements are not materially misstated, and therefore, they are free of material errors, irregularities, and fraud. This level of assurance is given in an audit report on the basis of an audit of financial statements.

SAS No. 99 states that “absolute assurance is not attainable and thus even a properly planned and performed audit may not detect a material misstatement resulting from fraud.”³⁴ SAS No. 99 requires auditors to (1) approach every audit with professional skepticism; (2) discuss among the audit team members regarding the risks of material misstatement caused by fraud; (3) identify fraud risk and management incentives, opportunities, and ability to rationalize occurrence of fraud; and (4) design audit tests responsive to the risks of fraud. SAS No. 99 requires that auditors place an increased emphasis on discovering FSF.

Although SAS No. 99 is not suggesting any changes to the auditor’s current responsibilities for detecting fraud in a financial statement, it provides new guidelines, concepts, and requirements to aid auditors in fulfilling those responsibilities.

These guidelines

The 2010 inspection reports of the Public Company Accounting Oversight Board (PCAOB) indicate that audit failures of detecting financial misstatements including FSF have contributed to 2007 to 2008 financial crisis.³⁵ External auditors failed to perform their gatekeeping responsibility of protecting investors from receiving misleading financial reports by (1) not challenging the assumptions of valuation models used in estimating fair value assets; (2) not considering risk assessment of off-balance sheet transactions; and (3) not providing early signal of financial difficulties and going concern.³⁶ Auditing standards (SAS Nos 88 and 99, 2002) define independent auditor responsibility in rendering an unqualified opinion is to express reasonable assurance that the audited financial statements are free from material misstatements, whether caused by error or fraud. Results of a survey indicate that external auditors can reduce the likelihood of FSF by (1) performing risk-based audit tests; (2) discussing FSF with the board, audit committee, and management; (3) integrating fraud risk into audit strategies, plans, and procedures; and (4) performing forensic and investigative audit procedures to detect FSF when there is likelihood of allegation of fraud. External auditors main concern is with material misstatements in the audited financial statements by reducing the information risk of be misleading and fraudulent.

Enron’s collapse and related audit failures caused loss of reputation, trust, and confidence in Big 5 accounting firm, Andersen, LLP. News about charges of inappropriate destruction of documents at the Andersen office in Houston, which housed the Enron audit and the subsequent unprecedented federal indictment, resulted in the demise of Andersen. Andersen’s clients quickly lost confidence in the auditing firm, and by June 2002, more than 400 of its largest clients had fired the firm as their auditor, leading to the sale or desertion of various pieces of Andersen’s U.S. and international practices. On June 15th, a federal jury in Houston convicted Andersen on a felony count of obstructing the SEC’s investigation into Enron’s collapse. Although the Supreme Court later overturned the decision in May 2005, the reversal came nearly 3 years after Andersen was essentially out of business. Shortly, after the June 15, 2002 verdict, Andersen announced it would cease auditing publicly owned clients by August 31. Therefore, like Enron, in less than a year Andersen went from being one of the world’s largest and most respected auditing firms into oblivion.

Andersen was regarded as the watchdog and moral voice of the auditing profession in the United States for many years before its demise in 2002, caused by the conviction of obstruction of justice. Although later the Supreme Court overturned Andersen’s initial U.S. District court conviction, it did not help Andersen to retain its severely damaged reputation. The Supreme Court decision did not save Andersen and did not change the perception that Andersen “was a victim of its own self-indulgence.” Nonetheless, a series of audit failures of Sunbeam, Waste Management, and Enron, among others, were devastating to investors and caused the public distrust of Andersen as it paid more than 500 million between 1997 and 2001 to settle claims of audit failures, looking the other way, and not reporting the discovered FSF.

Auditors must be skeptical, alert, professional, inquisitive, and understand the public trust in their profession and why they are licensed to serve as auditors. Their role is to lend credibility to published financial statements and provide reasonable assurance that financial statements fairly reflect underlying business realities, substance, financial conditions, and results of operations. SAS No. 99 defines skepticism as

an attitude that includes a questioning mind and a critical assessment of audit evidence. The auditor should conduct the engagement with a questioning mind that recognizes the possibility that a material misstatement due to fraud could be present, regardless of any past experiences with the entity and regardless of the auditor’s belief about management’s honesty and integrity.³⁷

Every publicly traded company has a right to be audited under the law. However, an audit is not an entitlement for receiving a clean or unqualified audit opinion. Some companies should not receive standard unqualified opinions until they clean up their act by providing objective, high-quality, reliable, and transparent financial statements. Auditors must be alert to management overriding controls, resulting in fraudulent financial reporting and misappropriation of assets.

The following suggestions can help the accounting profession to narrow the expectation gap:

Reasons auditors fail to detect FSF are as follows:

Short Sellers Role in Discovering Fraud

Short sellers as sophisticated investors and in looking after their investments also act as gatekeepers in preventing, detecting, and correcting irregularities, and errors and fraud. However, auditors’ efficacy and incentives in discovering and reporting FSF may be different from those of short sellers in the sense that auditors are concerned with fair presentation of financial statements and provide reasonable assurance that these statements are free from material misstatements, whether caused by errors or fraud, whereas short sellers search for financial challenges that influence short interest. Short sellers, through their private search and information processing skill, can identify firms with financial challenges and take actions before public disclosure of such information, and thus public disclosure of such challenges has no value relevant to short sellers. Short sellers tend to target firms with financial challenges, including irregularities, red flags of financial reporting fraud, and reported material weaknesses in their internal controls, top executive resignations, and auditor changes, and can obtain information faster than other traders before such information is publicly disclosed and reflected in stock prices.³⁸ Short sellers play an important role in the financial market and their incentives in targeting firms with financial challenges, including misstatements caused by fraud.

Forensic Accountants Role in Discovering Fraud

Forensic accountants combine accounting knowledge with investigative skills. Using this skill set, forensic accountants lend litigation support and conduct investigations in accounting settings. They are responsible for performing forensic research to trace funds and identify assets for recovery, conducting forensic analysis of financial data, and preparing forensic accounting reports from any financial findings.³⁹ Forensic accountants are responsible for finding a resolution for fraud allegations. This means performing a myriad of tasks including aiding in the prevention and detection of white-collar crime, collecting evidence (physical and verbal testimony), writing reports, and testifying to their findings.⁴⁰ Because of the important role the forensic accountants play, their knowledge base includes white-collar crime, money laundering, insurance claims, GAAP or generally accepted auditing standards (GAAS) violations, telemarketing fraud, check kiting, contract and procurement fraud, asset misappropriation, securities fraud, FSF, bankruptcy fraud, credit card fraud, embezzlement, financial data analysis, evidence integrity analysis, computer application design, damage assessment, tracing illicit funds, locating hidden assets, due diligence reviews, forensic intelligence gathering, accounting procedures, legal system and its procedures, regression analysis, and computer applications. They must possess the skill to write reports of high import as well as reliably testify as an expert witness, and their abilities must include interpersonal communication verbal communication, written communication, and attention to detail, analytical, integrity, objectivity, independence, and credibility.⁴¹ The common ways forensic Accountants assist business organizations in performing forensic accounting services are:

Certified Fraud Examiners passing the CFE Examination requires expert knowledge of fraudulent financial transactions, legal elements of fraud, fraud investigation, and criminology and ethics. In the investigation step of the fraud examination process, individuals working in the public and private sectors are key. Public-sector investigators work at the federal, state, or local level as police detectives, federal special agents, and anything in-between. Private-sector investigators work in the field of loss prevention, internal or external fraud analysis, and as independent or agency private investigations.

Specific job positions for the public sector include state and local police, police detective, crime scene investigator, district attorney investigator, attorney general, state bureau of investigation, Security and Exchange Commission, Homeland Security, U.S. Immigration and Customs Enforcement (ICE), Transportation Security Administration (TSA), U.S. Customs and Border Protection (CBP), Department of Justice, Federal Bureau of Investigation (FBI), Criminal Division, Civil Division, Central Intelligence Agency (CIA), Bureau of Alcohol Tobacco and Firearms (ATF), and the Drug Enforcement Administration (DEA).

The knowledge required of a public-sector investigator is white-collar crime, organized crime, financial crime, bribery and corruption, money laundering, counterfeiting, fraudulent documents, and credit card fraud. Much like a forensic accountant, an investigator should be proficient in the skills of writing reports and testifying in court, but they must also conduct surveillance, collect evidence, conduct interviews, record examination, and utilize computers. Important abilities required of public-sector investigators are attention to detail, ability to function in stressful situations, alert to surroundings, understanding of associated risks, honesty, sound judgment, integrity, responsibility, fairness, compassion, leadership, accountability, and adaptability.⁴²

Specific job positions for private-sector investigators include loss prevention, private investigator, internal fraud analyst, and external fraud analyst. The knowledge required of a public-sector investigator is the same as that of the public-sector accounting along with the addition of loss prevention and counterfeiting. They must have the skills to conduct surveillance, collect evidence, conduct interviews, record examination, writing reports, and utilize computers. The abilities required of private-sector investigators are attention to detail, functioning in stressful situations, being alert to surroundings, understanding associated risks, honesty, having sound judgment, high integrity, being responsible, and a having a strong judge of character.⁴³

Antifraud Role of Market, Regulators, and Standard Setters

Limitations in GAAP are at least partly to blame for Enron executives’ ability to hide debt, keeping it off the company’s financial statements. These technical accounting standards lay out specific “bright-line” rules that read much like the tax or criminal law codes. Some observers of the profession argue that by attempting to outline every accounting situation in detail, standard-setters are trying to create a specific decision model for every imaginable situation. However, very specific rules create an opportunity for clever lawyers, investment bankers, and accountants to create entities and transactions that circumvent the intent of the rules while still conforming to the “letter of the law.” SPEs were never intended to provide safe harbor to keep assets and liabilities out of a company’s accounting records. In contract, for an SPE’s assets and liabilities to be treated as “off-balance sheet,” Enron needed to maintain at least a 3 percent ownership in the SPE and the remaining debt, and equity investors needed to have their investment capital at risk.

Enron structured the transactions so that it virtually guaranteed the investors’ positions. As such, the SPE and its related assets and liabilities should have been consolidated as part of Enron. Because the SPEs were not consolidated, Enron’s risk remained hidden by a veil of deception in the form of the SPEs. When Enron’s guarantees came to light during 2001, the market’s trust in Enron’s ability to deliver as a market maker evaporated. Even more interesting was that Enron executives had significant financial stakes in some of these SPEs and personally reaped huge income from that ownership. For example, Michael Kopper, a Fastow assistant, is reported to have made at least $12 million and Andrew Fastow, CFO, more than $30 million on their related party investments in Enron off-balance sheet entities.

Enron created four SPEs in 2000. As part of the initial capitalization of these SPEs and a series of ongoing transactions, Enron issued its own common stock in exchange for notes receivable. At the time, Enron increased notes receivable (an asset) and shareholders’ equity to reflect these transactions. However, GAAP generally requires that notes receivable arising from transactions involving a company’s capital stock be presented as deductions from stockholders’ equity and not as assets. Enron has indicated that they overstated both total assets and shareholders’ equity by $172 million owing to a transaction first reported in the financial statements for the quarter ended June 30, 2000, and by an additional $828 million owing to a transaction first reported in the quarter ended March 31, 2001. Even with these accounting mistreatments, Enron was demonstrating signs of impending financial troubles. In the first and second quarter of 2001, Enron reported negative cash flows from operations in contrast to reporting operating earnings. Regulations and standards that are cost-effective, efficient, proactive, and scalable provide framework and guidelines for business organizations in developing sound business and accounting systems to prevent, detect, and correct FSF, and proper guidelines for forensic accountants and auditors to discover and report FSF.

Market Correction Mechanisms

Market can play an important role in preventing and detecting FSF by demanding full and fair disclosure of financial information of the listed public companies. Financial analysts, following public companies for compliance with listing standards pertaining to full and fair disclosures and revealing non-compliance, can cause a substantial reduction in stock prices. Any market correction mechanism for disclosure of fraudulent activities can be detrimental to companies. The capital market can monitor and punish fraud-prone companies through negative stock reactions to fraud disclosures. These negative stock reactions usually get the attention of the board of directors in replacing management and establishing effective corporate governance measures to correct fraud. However, in many fraud cases including the Enron case, by the time that the market reacts to undisclosed and disclosed frauds, these fraud companies are already bankrupt or on their way to becoming insolvent.

Academic studies, by using “fraud-on-the-market theory,” find that on average stock prices are negatively affected by the disclosure of FSF.⁴⁴ The question is whether the market price is fraudulently being distorted, suggesting that stock prices are different from what they would have been in the absence of such disclosure. The fraud-on-the-market theory suggests that in an efficient market, stock prices reflect all available public information including misstatements caused by FSF, presumably at the disclosure time of FSF. However, the securities market may not be aware of occurrences of FSF before public disclosure, and thus their effects are not embedded in stock prices. It is also possible that stock prices are distorted by disclosures of FSF. A combination of the fraud-on-the-market theory and the bad news concealing theory derived from the agency problem suggests that there is an information asymmetry between management and shareholders that can motivate management to engage in FSF that may affect stock prices According to the fraud-on-the-market theory, the stock price reflects all information, including the misstatement caused by fraud. Therefore, if an investor can show that the purchased stock was priced much higher because the market price did not reflect the fraud when the fraud was not disclosed to the market, the investor has the grounds for a class-action lawsuit.⁴⁵

There is nothing wrong with markets failing to fulfill their task of leveling the playing field between buyer and seller. Such market failures are in fact how many entities make their money through patents (temporary monopolies) and the use of expertise that is not universally available (competitive advantage). Nonetheless, the types of market failures that ignore the rights of others and endanger the credibility of all legitimate transactions have detrimental effects on business and market sustainability. The most common form of market failure is information asymmetries known to business decision makers (management) and not properly disclosed to investors. Thus, this unfairness information asymmetry exceeds simple competitive advantage and is a threat to the rights of investors and to the effective functioning of the free market system. An obvious example of this market failure is the use of “off-balance sheet,” SPEs, and other related party entities by Enron with the intention to hide liabilities and exaggerate earnings. When an entity acts as a market marker, optimally, the market maker has no ownership positions in the assets and liabilities being traded; instead, the market maker assists willing buyers and willing sellers meet in an effective, efficient, and low-cost manner. The trouble with Enron was that in many of its markets, it was a counterparty to the transaction. Enron’s inventory of energy and other assets also created enormous debt. Enron used about five hundred SPEs and thousands of questionable partnerships for the structure transactions to achieve off-balance sheet treatment of assets and liabilities. Enron used SPEs to borrow directly from outside lenders, often supplying its own credit and stock guarantees. When outside investors became suspicious of the value of the SPEs, Enron offered its own stock as collateral.

In the natural gas market, Enron provided and charged for stability, marketing stable financial contracts to its customer by combining of options, swap, and similar financial instruments. The problem at Enron was that many of their contracts were custom and did not have a ready market. Custom contracts without a market are difficult to value. The alternative was that Enron valued these contracts through computer models, a process known as mark-to-model. The immediate advantage is that Enron could put a positive spin on its earnings. But the end result was: Enron not only started to believe that mark-to-model earnings were real, but also “manipulated the models to its advantage.” The capital market is expected to discipline underperformed and unethical companies through extensive sales of shares of these companies and lack of investor confidence that causes substantial declines in stock prices. Exhibit 3.5 shows Enron’s stock decline during the Enron debacle in 2001.

Antifraud Role of Regulators

The SECs have several divisions related to fraud and regulatory enforcement. Under the purview of the Financial Reporting and Audit Task Force, the team investigates violations related to financial information and disclosure. The SEC’s Financial Reporting and Audit Task Force is also responsible for fraud detection through use of real-time analysis, running systems designed to detect fraud, and using experts to pinpoint and properly address fraudulent behavior. This task force communicates its findings with several offices, including the Chief Accountant, Economic and Risk Analysis, and Corporate Finance.⁴⁶

The Microcap Fraud Task Force, created in 2010, joined several different operations in the enforcement and examined functions of the SEC. Research and investigative techniques are used on only microcap securities. Microcap securities have a capitalization value between $50 and $300 million. As a result, the task force is concerned about a specific set of actions, people, and firms and develops strategies on the basis of this optic. Elisha Frank and Michael Paley are currently in charge of this task force.⁴⁷

The previously mentioned task forces were created to discover fraud. The SEC uses these groups to find fraud, but there is a general process that the agency follows. An investigation is opened first, then proceedings occur, and then finally is investigated, enforced and then closed. When opening an investigation, the SEC has two methodologies to choose from. The first method occurs when a Matters Under Inquiry (MUI) is translated into an investigation. When a MUI becomes investigative, the SEC has determined that a MUI is no longer applicable given the conclusions of the analysis. Second, an investigation may be opened when no MUI is present.⁴⁸

To open an investigation, several questions must be considered about the validation of evidence, the resources used, and the conduct in which the investigation will be done. The investigations are required to be administered to benefit the public and investors in the public sector. As a result, the SEC needs to be thorough in the processes leading up to investigation closure.⁴⁹ Factors that should be contemplated when deciding whether to close an investigation are: the seriousness of the conduct and potential violations, the staff resources available to pursue the investigation, the sufficiency and strength of the evidence, the extent of potential investor harm if an action is not commenced, and the age of the conduct underlying the potential violations. Once the decision is made to close an investigation, there are several steps that a staff must take, including checking with the Freedom of Information Act Office (for instructions of retention and disposition of case files), preparing a closing recommendation, preparing the files for disposition, and generating and sending the proper termination notices. However, should a case result in enforcement action, it can’t be closed until all enforcement actions in the case are completed. This mandates a final judgment/commission order and that all ordered monetary relief be accounted for.⁵⁰

SEC enforcement actions are taken against firms that are identified as having violated the financial reporting requirements of the Securities Exchange Act of 1934. The SEC Enforcement Manual provides guidance to employees about the handling of complaints, tips, and referrals (leads) received concerning violations of SEC requirements. The SEC obtains leads for investigation from several sources: (1) public complaints and tips; (2) the reporting requirements of federal, state, and local law enforcement agencies under the Bank Secrecy Act; (3) the enforcement staff of the Public Company Accounting Oversight Board; (4) the enforcement of “blue sky laws” by state securities regulators; (5) complaints and other information from members of Congress on behalf of constituents whom they represent; and (6) trading-related referrals from domestic self-regulatory organizations (SROs).⁵¹

Antifraud Education

Effective antifraud policies and programs should be designed to prevent and detect fraud. Antifraud programs should deter, prevent, and detect all variations of fraud, from misrepresenting financial information to misappropriating assets and employee fraud. Effective antifraud programs should also address the antifraud role of corporate governance participants. Entities of all sizes are susceptible to both employee fraud (e.g., theft and embezzlement) and management fraud (e.g., manipulation of financial reports). Effective antifraud programs—focusing on fraud awareness and education in the workplace environment, whistle-blowing policies and procedures of encouraging and protecting employees to report suspicious behavior, adequate internal control procedures designed to prevent and detect fraud, and conducting surprise audits—can significantly reduce fraud.

The demand for and interest in ethics and corporate governance and antifraud practice and education has significantly increased in the post-SOX era. Ethics and corporate governance have transformed from a compliance process to a business strategic imperative—yet, many have expressed concern over the corporate governance and ethics education, as well as the training provided in an effective antifraud program. Antifraud policies and programs should address corporate culture, control structure, and fraud procedures.

Conclusion

Entities of all sizes and types are susceptible to both employee (e.g., theft and embezzlement) and management fraud (e.g., manipulating financial reports). Effective antifraud programs and procedures should be designed to prevent and detect fraud. Antifraud programs should deter, prevent, and detect all variations of fraud, from misrepresenting financial information to misappropriating assets and employee fraud. Effective antifraud programs should address the role of corporate governance participants including the board of directors, executives and auditors in preventing and detecting fraud. This chapter provides insights on the role of corporate governance participants in antifraud policies and procedures. Corporate culture should create an environment that sets an appropriate tone at the top, promoting ethical behavior, reinforcing antifraud conduct, and demanding “doing the right thing always.” It provides incentives for everyone in the company to act ethically. Control structure should eliminate opportunities for individuals to engage in fraudulent activities. Antifraud procedures are necessary to ensure prevention and detection of potential fraud.

The collapse of Enron, WorldCom, and Global Crossing, among others, caused by the alleged FSF has encouraged organizations to place more emphasis on corporate governances, information systems, and internal control in generating online and real-time, reliable, relevant, and transparent financial information. The internal audit function is an important component of corporate governance and the first line of defence against FSF. The three-factor model consisting of conditions, corporate structure, and choice discussed in this chapter should assist internal auditors and forensic accountants to identify symptoms and red flags that may indicate the occurrence of FSF, assess the identified symptoms and opportunities, and notify the appropriate authorities within their organization for investigation of the possibility of FSF.

FSF occurs when one or a combination of antifraud strategies presented in this chapter are relaxed owing to self-interest, lack of due diligence, pressure, over-reliance, or lack of dedication. The opportunity of occurrence of FSF is significantly increased when antifraud strategies are inadequate and ineffective. The opportunity to engage in FSF increases as the organization’s control structure weakens, its corporate governance becomes ineffective, and its audit efficacy deteriorates. One important lesson learned from Enron’s collapse is the relevance and importance of a proactive, responsible, and vigilant corporate governance, including internal and external audit functions in ensuring the quality, integrity, transparency, and reliability of the financial reporting process. As an active participant in corporate governance and front-line combatants in the recent struggle against occupational fraud, corporate abuse, and FSF, forensic accountants must play an important role in improving the quality and quantity of public financial information.

Action Items

Endnotes