Key Points to Cover in Corporate Financial Status Reviews

The Impact of Fraud and Abuse Can Far Exceed the Value of Stolen Money—Civil Penalties Are Often Exorbitant

Clients often look to their attorneys as trusted advisors on the issue of prevention of corporate fraud, waste, and abuse. In this article, Joe Epps identifies the impact occupational fraud and abuse has on a company; present governmental oversight issues associated with fraud and abuse; and several common corruption schemes. He offers recommendations regarding types of accounting evidence and methods necessary to support a financial status review.

Clients often look to their attorneys as trusted advisors on the issue of prevention of corporate fraud, waste, and abuse. The intent of this article is to identify the impact occupational fraud and abuse has on a company; present governmental oversight issues associated with fraud and abuse; identify several corruption schemes; and provide recommendations regarding types of accounting evidence and methods necessary to support a financial status review.

Impact of Fraud and Abuse

Fraud is an intentional deception for personal or corporate gain, which causes injury or damages. According to Wells (2005), not all deceptions are indicative of fraud; it is true, however, that all frauds use “deception as its principal modus operandi” (Wells, 2005, p. 8).  Management is keenly aware of the impact fraud and abuse has on the organization.  It bears repeating that fraud and abuse cost jobs, benefits, profits, and deteriorate overall morale (Wells, 2005, p. 400).

Costs do not end there. In November 1991, the United States Congress allowed a series of guidelines to be enacted as laws, which dramatically increased the potential for exorbitant civil penalties as well as punitive actions against businesses and individuals. The Corporate Sentencing Guidelines associated with these laws create a dangerous environment for corporations, which can be subject to vicarious and imputed criminal liability.

The fines associated with an adverse outcome can range up to $290 million and place the corporation on probation for up to five years (Wells, 2005, p. 403). Under tort law, as a general rule, a principal is not liable for torts committed by its agents; however, an exception exists with regard to employers. Under the doctrine of respondeat superior, an employer may be found liable for an employee’s torts that are committed within the scope of that employee’s employment. Therefore, it is paramount for principals to always consider the impact fraud and abuse can have on the company and should not be overlooked.

Governmental Oversight Issues

The power to establish Generally Accepted Accounting Principles (GAAP) rests with the Securities and Exchange Commission (SEC); however, except for rare instances, it has essentially allowed the accounting profession itself to establish GAAP and self-regulate. Unfortunately, in recent years, accounting scandals and notorious frauds have brought the issue to the forefront of the SEC’s mission.

In September 1998, the Chairman of the SEC, Arthur Levitt, while speaking at a prominent university, announced “an all-out war on the kinds of accounting and reporting procedures collectively referred to here as creative accounting practices” (Mulford & Comiskey, 2002, p. 93).

The main role of the SEC is to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital information” (SEC, 2011). Both the Securities Act of 1933 and the Securities Exchange Act of 1934 govern the registration of securities by publicly traded corporations. The laws require standardized disclosure of financial information and other information, and for oversight and compliance enforcement (Mulford & Comiskey, 2002, p. 108).

The SEC’s Division of Enforcement is tasked with conducting routine investigations into violations of securities laws. If cause exists, the Division of Enforcement files its complaint in federal courts seeking either civil and/or criminal prosecution. The SEC has identified common violations, which are as follows (SEC, 2011):

• Misrepresentation or omission of important information about securities;
• Manipulating the market prices of securities;
• Stealing customer’s funds or securities;
• Violating broker-dealers’ responsibility to treat customers fairly;
• Insider trading;
• Selling unregistered securities

The types of frauds identified above are just a few and should not be construed as comprehensive. Moreover, it is likely any potential oversight conducted by the SEC or any other governmental entity would be most interested in ascertaining whether or not the company’s accounting records have been manipulated, falsified, altered, or misrepresented with intent to deceive and cause damage. A financial status review would allow management to know what would be found in the event an investigation is conducted by the government.

Corruption Schemes

Joseph Wells, a prominent fraud examiner, has written several books on the topic of occupational fraud. In his text entitled, Corporate Fraud Handbook, Wells (2007) identified four different corruption type fraud schemes, which are as follows (Wells, 2007, p. 275):

• Conflict of interest;
• Bribery;
• Illegal gratuities; and
• Economic extortion

The above-identified schemes are very similar in nature and ultimately expose corporate employees and potentially the company to potential civil and criminal prosecution and Corporate Sentencing Guidelines. Bribery is widely known as the offering, giving, receiving, or soliciting anything of value to influence an official act.

Key Points to Cover in Corporate Financial Status Reviews

The afore-mentioned “official act” typically refers to a decision to be made by an agent of the government. Illegal gratuities represent a promise of payment; however, most professional and corporate policies specifically forbid the acceptance of unreported gifts from vendors. Economic extortion represents the “pay-up-or-else” type of corruption fraud schemes (Wells, 2007, p. 282).

Essentially, an individual demands payment from someone else who threatens some type of harm, such as the loss of business. Conflict–of-interest schemes occur when an employee or manager obtain a personal interest in an undisclosed transaction that is in direct conflict with their fiduciary duty to the company. Each scheme, if found in our company, could potentially affect the bid process. The financial status review may discover these issues if conducted prior to starting the bid process.

Method and Evidence

Fraud examinations require the development of evidence that speak to the nuances of the fraud schemes being investigated. However, before any examination begins, the fraud examiner must be based on proper predication. The concept of predication is concerned with understanding the totality of circumstances surrounding the alleged fraud. If the proper predication does not exist, the fraud examination should not be performed. However, if proper predication exists, then the fraud examiner will likely approach the investigation using the following steps (Wells, 2005, p. 5):

• Analyze the available data;
• Create a hypothesis;
• Test the hypothesis; and
• Refine and amend the hypothesis 

Data, in general terms, is information and documentation that leads the fraud examiner through each of the above-itemized steps. Data can also be evidence, it  conforms to the rules of evidence, as defined by the courts. For our purposes, evidence can be defined as anything that proves or disproves any matter in question.

Summary

Each of the issues presented in the body of this article are intended to address issues germane to company’s financial status reviews. Specifically, this article identified the impact of occupational fraud and abuse; presented governmental oversight issues associated with fraud and abuse; identified several corruption schemes; and provided recommendations regarding types of accounting evidence and methods necessary to support the financial status review. Based on the issues presented in this article, attorneys tasked with advising executive members of corporations should seriously consider suggesting periodic financial status reviews, which focus on combating fraud, waste, and abuse.

References:

Wells, J.T. (2005). Principles of Fraud Examination. Hoboken, NJ: John Wiley & Sons, Inc.

Mulford, C. W., & Comiskey, E. E. (2002). The Financial Numbers Game: Detecting Creative Accounting Practices. New York, NY: Wiley.

SEC. (2011). The Investor’s Advocate: How the SEC Protects Investors, Maintains Market Integrity, and Facilitates Capital Formation. Retrieved on 11/17/11 from http://sec.gov/about/whatwedo.shtml

Wells, J.T. (2007). Corporate Fraud Handbook—Prevention and Detection (2^nd Edition). Hoboken, NJ: John Wiley & Sons, Inc.

Joe Epps, CPA/CFF/ABV, CFE, CVA can be reached at jepps@eppscpa.com