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Working Together to Fight Financial Reporting Fraud

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Enron. Worldcom. Adelphia. Once upon a time, all were successful companies, the envy of the business world. Until each was undone by financial fraud perpetrated by corporate leadership. When major frauds like these are discovered, investors are left angry and the markets in disarray. We wonder why we didn't see it coming. We ask, "How did this happen?"

What compels someone to commit fraud -- to work hard, rise to the top, then undo his or her life's work by committing a crime? That question led the Center for Audit Quality (CAQ) to launch an ambitious effort to understand financial reporting fraud, and to mitigate the conditions that can lead to such fraudulent behavior. As part of that initiative, the CAQ has established the first cross functional working group to develop tools and further research on deterring and detecting financial reporting fraud.

The partnership is made up of leading organizations representing those with responsibility for the public company financial reporting "supply chain": company management through Financial Executives International (FEI); audit committees through the National Association of Corporate Directors (NACD); internal auditors through The Institute of Internal Auditors (The IIA); and external auditors through the CAQ.

This partnership is the outgrowth of a report released in October by the CAQ, Deterring and Detecting Financial Reporting Fraud - A Platform for Action. The basis of the report was a series of roundtable discussions attended by more than 100 stakeholders, and led by Michele Hooper, the CAQ Governing Board's Co-Vice Chair, public company audit committee chair, and corporate governance expert. The report argues that a collective sharing of ideas and resources will advance efforts to detect and deter fraud to the benefit of investors and the capital markets.

The CAQ's anti-fraud partnership with FEI, NACD and The IIA will engage in activities designed to help foster an overall environment in which the risk of financial reporting fraud is minimized. The essential elements of such an environment include a) having a strong "tone at the top" - a strong corporate culture that expects employees to "do the right thing" throughout all levels of a company; b) robust and frequent communication among company management, their board members, and the external auditor to share information relevant to the company's financial reports and control environment and to identify gaps in fraud monitoring; and c) the application of skepticism, a questioning mindset that leads to professional objectivity and an attitude of "trust, but verify."

The partnership is designed to leverage the experience and resources of the four groups to produce new and better tools and resources to help the supply chain more effectively deter and detect fraud. Initial work will focus on four broad areas:

  • Advancing the understanding of the conditions that contribute to fraud to better understand the pre-conditions and indicators of financial reporting fraud.
  • Promoting enhanced skepticism that is able to overcome a natural inclination to trust management and others involved in financial reporting without creating a hostile environment.
  • Moderating the risks inherent in focusing only on short-term results.
  • Exploring the role of information technology, which can be both an inhibitor and a facilitator of financial statement fraud, to maximize its potential to inhibit fraud.

The anti-fraud partnership soon will consider next steps within the four areas of focus, with the goal of making recommendations for specific projects early next year. One of those steps will be exploring the psychology behind fraudulent behavior to expand our understanding of "Why?"

According to one expert observer in the CAQ's new report, "Most people who come unstuck in this context of accounting misstatement are basically honest people who get caught up and then they get desperate." Through the work of our collaborative partnership, our goal is not only to better understand why people commit fraud, but also spot the warning signs before it's too late.