Forensic accountants' role in detecting and preventing fraud

¶ … forensic accountants and their role in detecting / preventing fraud. This will be accomplished by focusing on the most common types of frauds and the way they are impacting stakeholders. Once this occurs, is when we can provide specific insights that will highlight how these challenges can be mitigated over the long-term.

Over the last several years, the issue of ethics in forensic accounting has been increasingly brought to the forefront. This is because there have been a number of high profile scandals highlighting potential abuses that occurred at the hands of actuaries. In some cases, these individuals often overlooked critical information that could have uncovered a potential fraud. While at other times, they were overly influenced by corporate officials. In either case, the long-term impacts are that investors will lack confidence in the firm and the financial system. (Golden, 2011)

Evidence of this can be seen with a study that was conducted by Price Waterhouse Cooper. They found that in 2009, fraudulent incidents impacted 30% of all U.S. publically traded firms over a 12-month time frame. This is lower than 2007, with these figures coming in at 43%. Moreover, European and Russian companies experienced some of the highest levels of fraud. In these cases, firms reported incidents of 43% for Europe and 71% for Russia. This is problematic, as these kinds of challenges can lead to reduced investor confidence. If the situation continues over long periods of time, there is the possibility that this could erode investor sentiment and their access to investment capital. To fully understand the overall scope of the problem we will be focusing on areas where fraud is prevalent in forensic accounting. Together these different elements will highlight the underlying challenges and provide possible solutions for rectifying them. (Golden, 2011)

Ethics and Fraud in Forensic Accounting

Forensic accountants have the responsibility of adhering to various ethical standards that are established by the Securities and Exchange Commission (SEC) along with Financial Accounting Oversight Board (FASB). These guidelines provide a basic foundation for ethical activities embraced corporate executives and actuaries. Moreover, they established different techniques of reporting financial information and determining if fraud is being committed inside the organization. The most notable include: auditing tests, sampling, interview / interrogation techniques, verbal / nonverbal cues and questioning different individuals. This is augmented with a basic standard that requires everyone to follow the most ethical guidelines during the process. The combination of these factors is showing how forensic accountants play an important part in enforcing these standards and detecting possible fraud. (Gray, 2008)

Types of Frauds that are most Prevalent

Inaccurately Representing Information inside the Financial Statements

Another common type of fraud is the misrepresentation of information that is presented to investors in various pieces of financial data (i.e. quarterly and annual reports). In the majority of cases, these kinds of activities are tied with the desire of management to help increase the price of their stock or the value of their company. This is because they do not want to take significant losses from particular activities that were unsuccessful (which could hurt perceptions about future growth). It is at this point that executives will engage in actions that are considered to be unethical and illegal. (Healy, 2003)

A good example of this can be seen by looking no further than Enron. During the late 1980s and into the 1990s, the company was aggressively taking advantage of deregulation that was occurring around the world. The way the company was able to increase their profit margins were through: trading in the distribution of key commodities (i.e. electricity and natural gas) along with owning facilities that can produce them. (Healy, 2003)

To take advantage of new opportunities the company began going into developing economies. One of the most notable was the investment the firm made in building a liquefied natural gas power plant in Dabnol, India. At the time, this was supposed to provide the company with a significant footprint in the region through constructing a modern facility. In the future, this would address the current and future needs of region. (Healy, 2003)

However, from the very beginning the company was facing tremendous problems with: cost overruns, they did not account for the loss of electricity (because of theft) and failed to take into account that LNG plants require billions of dollars in infrastructure. Moreover, the local economy was unable to support this kind of facility. The combination of these factors made the underlying situation worse, as the Indian government stopped supporting the development of the plant. When this happened, the company was forced to abandon the project and take a $20 billion loss. (Healy, 2003)

Evidence of this can be seen with observations from Healy (2003) who said, "Enron International, a wholly owned subsidiary of Enron, was created to construct and manage energy assets outside the United States, particularly in markets where energy was being deregulated. They subsequently entered contracts to construct and manage projects in Eastern Europe, Africa, the Middle East, India, China and Central / South America. These projects represented significant investments in these economies. While the privatization of energy producers and deregulation of energy markets created demand for the management of energy assets outside the United States, Enron faced some distinctive risks in entering these new markets. The Dabhol power project in India represented the single largest foreign direct investment until that time in India, and it attracted considerable political opposition and controversy. Given its limited business experience in developing economies, Enron did not have expertise in managing the risk or accounting for if its assets would be expropriated after construction of the plant. Even if Enron was successful in the international energy market, questions could be raised about whether the company can create a sustainable advantages over competitors that later sought to enter the market. As many existing players had expertise in managing the construction and operations of power plants." This is showing how Enron faced tremendous challenges with these projects. In most cases, forensic accountants were able to overlook these issues or were unaware of them. This is because they did not watch for obvious signs of abuse, which allowed the firm to engage in activities that will produce limited long-term rewards for them. (Healy, 2003)

To hide these losses, they created off the book limited partnerships. These were designed to provide investors with larger returns by compensating them with Enron stock. In the late 1990s, this was not a problem as the stock was continuing to climb to all-time highs. However, once the economy began to slow, is when this strategy backfired by forcing them to issues more stock to cover these losses. As shares were declining, many investors became weary of continuing to participate in these activities. (Healy, 2003)

In late 2001, these activities were brought to the attention of regulators and investors (which resulted in the eventual bankruptcy of the firm). This is illustrating how forensic accounts overlooked or ignored key areas that could have uncovered fraudulent activities. As a result, one could argue that the lack of ethics and the close relationship with company executives helped to perpetuate these abuses. (Healy, 2003)

Insider Trading

Another type of fraud that is most prevalent is insider trading. This is when executives will have specific knowledge of the financial situation surrounding the firm and they will begin purchasing or selling the company's stock in advance. The basic idea is to take advantage of the price irregularities before the rest of the market has a chance to discover what happened. In forensic accounting any kind of large buys or sells could be a sign that executives are aware of this information. This is a violation of the Securities and Exchange Act of 1934. As the law, requires that executives must disclose (to the SEC) their intentions in advance of conducting the transaction. (Jagolizinnger, 2009) (Bettis, 2000)

However, most executives will often say one thing to: their employees, regulators and the general public. Yet, privately they will be engaging in activities that are in direct contradiction to what they are telling others. When this happens, these individuals will receive significant advantages at the expense of stakeholders. (Jagolizinnger, 2009) (Bettis, 2000)

A good example of this occurred with World Com. During the 1990s; the company was rapidly taking advantage of deregulation in the telecommunications industry. The idea is that they could use this as a way to become a major communications and Internet provider throughout the U.S. This resulted in the firm acquiring a number of assets that helped to increase their size and market share. (Jagolizinnger, 2009) (Bettis, 2000) (Albrecht, 2006)

To achieve these objectives, management would often use their common stock as currency and acquired significant amounts of debt. The problem with this approach is that World Com was purchasing firms with funds they did not have. This meant that these activities would normally have an adverse impact on their stock price under GAAP accounting standards. To deal with these challenges, the firm would take smaller write offs for the losses over a period of many years (versus right away). When the economy was strong, this helped World Com to grow exponentially. (Jagolizinnger, 2009) (Bettis, 2000) (Albrecht, 2006)

However, once a slowdown occurred, is when these issues became problematic for executives. This is because the company was having trouble growing their earnings through acquisition. Moreover, the previous purchases caused the debt load to cripple the firm's ability to obtain financing. This created a situation where World Com had trouble meeting their expenses. (Jagolizinnger, 2009) (Bettis, 2000) (Albrecht, 2006)

Bernard Ebbers (the CEO) realized what was happening and quickly began selling a large number of his holdings in the company. While at the same time, he was telling stakeholders and regulators that the firm was financially sound. To make matters worse, he approached the board of directors about them giving him loans to help complete his large purchases of different pieces of real estate around the country. This is a sign that Ebbers knew his company was in financial trouble and wanted to save his own investments at any cost. The fact that he did not disclose this to regulators or investors (until after these sales) is a sign that he intentionally wanted to protect himself. (Jagolizinnger, 2009) (Bettis, 2000) (Albrecht, 2006)

In this case, forensic accountants had a close relationship with the management and failed to reveal critical red flags of potential fraud. This is an indication there was a lack of ethics among actuaries. As they were willing to overlook these issues by: not questioning critical transactions, why they occurred or carefully scrutinizing the activities of executives. In many ways, one could argue that this close relationship is what allowed the fraud to continue (with the insider transactions serving as a tool to protect the net worth of unscrupulous company officials). (Jagolizinnger, 2009) (Bettis, 2000) (Albrecht, 2006)

Conclusion

Clearly, three areas where fraud is prevalent inside many corporations include: the misappropriation of company funds, inaccurately reporting information on financial statements and insider trading. What makes these issues so troubling; is the fact that forensic accountants often overlooked critical factors which could have identified and prevented these activities. However, because of their close relationship with company officials and a lack of ethics meant that these issues are often ignored. To deal with these challenges, all forensic accountants must have a sense of objectivity and a willingness to look out for the interests of stakeholders. If this can take place, it will be more difficult for these types of situations to develop. When this happens, stakeholders will have increased confidence in the company and the information that is provided. This should be the primary focus of forensic accountants at all times.