Fraud Prevention: Are Existing Deterrents Working?

TERM PAPER:

Fraud Prevention: Are Existing Deterrents Working

Kevin B. Hoover

ACC 630 – Professor Sheila Vagle

University of Maryland University College

Introduction

    I recently read the following quote posted by an anonymous person on Facebook:

“I had ADHD when I was a kid too, but when I saw my father taking off his belt, I was healed”. I share that not just because it is true in my case, but because it is a fairly humorous and spot on example of a deterrent.

    Deterrence is a critical element of the effort to prevent a particular behavior. People have to have a reason not to act that way. When I was a kid, I didn’t know what a deterrent was, but I sure knew that the possibility of a whipping was reason enough not to lose my mind.

    What deters people working in the business and financial worlds from committing fraud? The Sarbanes-Oxley Act of 2002 perhaps? Fear of prosecution? One would hope so, but it is certain that the answer is more complex than that. In fact, it could be argued that the answer is nothing deters people from committing fraud because fraud is still happening. Therein, lies the aim of this paper.

    This paper will take a look at financial fraud and the deterrents in place since 2002, and offer the opinion that the deterrents are not working. A history of the issues as they relate to this opinion will be given. Further, recommended solutions to the perceived problems will be put forth. It is worthy of mention that deterrence and prevention are treated as synonymous from this point forward. No effort will be made to distinguish a difference between the two concepts.

Problem Statement

    Simply put, fraud deterrents in place are not working. I don’t believe the penalties for being found guilty of fraud are harsh enough, nor do I believe that the government has any real interest in improving deterrents to fraud.

History of the Issues

    Before any discussion of the history of the issues, it will serve the paper well to cover what current literature (defined for purposes of this paper as 2008-Present day) says about deterring fraud. The idea is to give an overview of the current opinions on fraud deterrence so readers can keep those opinions in mind while analyzing the “history of the issues” put forth following the overview.

    According to Law (2011), the American Institute of Certified Public Accountants (AICPA) has identified three criteria to deter fraud:

1. Culture of honesty and strong ethics (tone at the top);
2. Managerial responsibility; and
3. Audit Committee oversight. (p. 503)

Interestingly, there is no specific mention of internal controls. Wells (2008) says that if you were to ask a group of typical accountants what deters fraud, they would respond in unison: “Internal Control!” (p. 6). Wells says that using this logic, companies with adequate controls would not have fraud. But they do, time and again.

    Bryan (2012) also advocates tone at the top and a strong ethical culture to deter fraud (pp. 22-23). A concept Bryan introduces (not mentioned by the AICPA) is that of professional skepticism. Developing healthy skeptics helps build critical thinking skills which can provide benefits when developed in all groups of employees (p. 23). The idea is that employees develop the trust that it is okay for them to ask questions of other employees. Leaders must also let subordinates know it is ok to ask questions of them.

    Verschoor (2015) mostly echoes what Bryan stated, in that he advocates a strong commitment to ethical behavior from the top management and skepticism in the organization (p. 18). Verschoor adds that robust communication amongst participants in financial reporting is an important aspect of deterrence (p. 23). People involved in financial reporting should be able to talk throughout the process, question decisions (skepticism) and ask for clarification on any decisions they were not a part of.

    In summary of current literature, it is clear that a strong ethical culture or “tone from the top” and healthy skepticism up and down the organization are thought to be key tenets to prevent fraud. I couldn’t agree more such assessment. It absolutely starts at the top. There is no way to effectively control fraud in your organization if the top level managers don’t exude strong ethical behavior. I realize that the word skepticism has a certain negative connotation to it, but I also believe healthy skepticism is necessary for the organization to thrive. Sometimes it might as easy as asking a boss to explain a given decision. Whatever it is or isn’t, healthy skepticism certainly isn’t going to lead to anarchy or mutiny. Internal controls aren’t mentioned as prominently but perhaps that is because if the tenets above are followed, a strong internal control system would be implied to exist in such an organization. I will touch on some of these concepts again after I cover a “history of the issues”.

    The starting point for any discussion of financial fraud in the modern era has to begin with the collapse of Enron and to a lesser extent, the fraudulent activities at Adelphia, WorldCom and Tyco. In total, those cases resulted in nearly $500 billion in losses to investors (Ugrin, 2008, p.1). Enron, however, seems to be the scandal that gets singled out for being responsible for the passing of the 2002 Sarbanes-Oxley act (hereafter, SOX). SOX is where the discussion starts for me.

    SOX was the single most important piece of financial legislation since the Securities and Exchange Act of 1934. The Enron disaster had happened. Adelphia and WorldCom bankruptcies also happened prior to the passage of SOX, but the legislation was in its final stages before passage by the time those scandals came to fruition. I believe that is why the Enron scandal gets the credit for being the reason SOX was dreamed up in the first place.

    Ugrin (2008) writes that SOX was about restoring investor confidence in the U.S. Capital markets by improving corporate governance, the quality of audits, the strength of internal controls, increasing the severity of sanctions that can potentially be leveled against management for inaccurate financial reporting, and by imposing regulations requiring increased assessments of internal control by auditors (p. 2).

    Over the course of my educational career, I’ve written 3 papers on SOX and can attest to the fact that truly thorough analysis of SOX in its entirety is outside of the scope of this paper. I would, however, like to touch on some sections of SOX that have what I feel are the most relevance to the discussion of fraud deterrence.