The incidence of financial fraud has increased, probably as a consequence of the amplified pressures due to a dose of recession affecting the commercial world. This has exacerbated the pressures on auditors across the globe to look out for financial fraud which leads to material mis-statements arising out of intentional fraud and sometimes out of unintentional errors. The list of accounting scandals starting with Enron and the revelations following the dot-com collapse has multiplied such scandals starting of late with the sub-prime banking crisis, the Madoff-Ponzi scheme and now the unaccounted sovereign debt discovered in Greece national accounts. Other examples come to mind. Everyone remembers the classical fraud discovered in the famous Italian conglomerate Parmalat. This diary producer of international stature had to prop up its accounts by siphoning off millions of millions in euros and dollars, the likes of founder and owner Caristo Tanzi who it has been revealed, made use of experts. Such aid was forthcoming from technical advisors who would ensure that Parmalat selectively move funds from one tax regime to another. This is not the work of amateurs but of professionals, normally called upon to uphold fiscal and diligence in a company. The auditors were hoodwinked into believing a forged Bank of America deposit slip in Cayman of over US$7 billion. The Parmalat story carries on where the USs Enron left off, even if the Italian family run business may have started its shady deals way before Enron’s fraudulent practices.
Before examining the most common types of fraud and how to detect them, it is worth reviewing what fraud is, why it happens and how it manifests itself in various scenarios. By definition fraud can be better described as deception or misrepresentation that an individual or entity makes knowing that such misrepresentation could result in some unauthorized benefit to the individual or to the entity or some other third party. This definition therefore excludes errors or misconceptions on accounting estimates. Corruption is a cousin to fraud but takes a broader perspective and includes conflict of interest, bribery and bid –rigging. From an audit theory perspective, any fraud scheme is generally not detectable by traditional sampling and audit procedures, because frequently the transaction is not recorded. Therefore, auditors must understand that not all fraud schemes are detectable by traditional tests of controls. Fraud analytics may be more successful in detecting the probability of cash skimming but investigative procedures will be required to track the theft to its roots. At this stage one can quote the famous fraud triangle classically depicted by the late Donald R. Cressey, criminologist who specialised in this fraud dedection. Dr Cressey said three factors are typically present when a fraud occurs: rationalization, opportunity and pressure. To start with rationalisation as one of the three attributes the fraud triangle is the intention to cover one’s abusive attitudes by wilful justification. Secondly we have “pressure” a symptom closely tied to today’s deep recessionary environment which can easily influence management. Finally we have “opportunity” which simply explained can be attributed to such situations where fraud can be perpetrated due to lack of organizational controls and security. Therefore one can expect more “pressure” bearing on management when say the commercial environment places undue stress to meet operating targets in a downward spiral due to recession. In such instances it is the top culture that sends the message top –down by placing a disproportionate emphasis on financial results. This is prevalent in listed companies which compete to maintain their share price particularly when management is rewarded for exceptional performance by share bonus schemes. In this culture of “opportunity” we see how auditors have been careful to take a sceptical approach when examining client’s accounts although they are not responsible directly for detection of fraud. Looking for red flags is a practical way to decipher the existence of fraud whether it is arises due to error or intentional misappropriations of assets. Typically auditors will question why there are reportage of increased revenues without a corresponding increase in cash flow or why there exist highly complex transactions, particularly those that are closed near the year end. It is standard practice for auditors to examine any unusual growth in the number of days’ sales in debtor lists which may possibly account for fake sales invoices. These can be meant to jack up revenue. Overstating or improperly recognising revenues is a common form of financial statement fraud. The majority of cases of fraudulent financial reporting in listed companies involve making a company’s financial health appear better than it really is. Also be on the watch out for clever schemes which include understating cost of sales as a non-operating expense so it does not negatively affect gross margin. Another ploy is to improve profits by capitalising operating expenses, recording them as assets on the balance sheet instead of as expenses on the income statement. All this is usually associated with ddomineering management who over- rides internal controls and manipulates inventory balances at year-end simply but allowing a lax control over those responsible in conducting physical counts. Rationalisation means that the common attitude is that no one will miss the embezzled funds particularly in larger retail environments. A strong tool in the arsenal of the examiner is the use of analytical procedures.
These encompass a number of specific measures the examiner may perform. Examiners employ specific procedures to assess the reasonableness of data and to identify unusual relationships. Back to Malta we cannot forget the downfall of the Priceclub mega retailer. In 2003 MaltaToday reported that the accounts of Priceclub were audited for the periods ending December 1998 and 1999 . The auditor issued a clean bill of health in their audit opinion although they never finished auditing the accounts of 2000, because of “audit differences related to debtors and stocks.” Much journalistic fervour was demonstrated over this accounting scandal by the late Julian Manduca, (a MaltaToday journalist ). With hindsight we note how the euro 30 million insolvency was so majextic that it works out at 0.7 percent of the GDP in 2002. Eight years down the line since Priceclub collapse and we are no wiser although this is not due to any fault of the liquidator but just goes to show how complex are insolvencies of this kind.
The Priceclub turmoil has come to the fore following revelations of the evidence of shortcomings given in court by an in depth report compiled by PricewaterhouseCoopers.
PWC were commissioned by the major creditors to examine the books of account of Priceclub and report inter alia in relation to allegations of mismanagement by its directors. PWC reported serious shortcomings on stock controls. It revealed how the stock figures appearing in Priceclub’s accounts were overstated by Lm151,000 in 1998, after six months trading; by Lm772,000 in 1999 and by Lm504,000 in 2000. It is no consolation that the privileged creditors typically the banks have since re-possessed the retail premises and partially recouped their losses.
The same cannot be said for the rest of the unsecured suppliers who based their credit on the perception of business standing of the directors and audited accounts. They cry in the corner waiting for the recovery of some of their losses possibly by the liquidator claiming directly from directors. To conclude fraud is contagious and the implications for management to detect and eradicate it are paramount. Every organization is vulnerable to fraud, and managers must know how to detect it or at least when to suspect it. It is not surprising that management has to be vigilant as fraud and corruption in financial circles is a threat to the company’s own existence. At this stage one can fight fraud and abuse using a superior analytical tools which are recommended for auditors and government inspectors who have under their responsibility the reporting of opinions over assets held by clients or the State. The fight against fraud continues…………
