Introduction

A serious fraud, publicly exposed, will taint a corporation's reputation. This taint may extend to the corporation's board, to its management. and to anyone associated with the corporation.

In many cases involving serious fraud, the directors may be among the last to find out. This is hardly surprising: The perpetrators of large-scale frauds often go to extraordinary lengths to hide their wrongdoing. What can the directors do?

This chapter sets out ten factors, the existence of which might suggest to a vigilant board that a corporate environment is ripe for fraud to occur. These factors are based on the observations of a forensic accountant—an investigator who is hired to review and report upon allegations of financial irregularities.

The list is not intended as comprehensive or complete. Most importantly, just because an observer sees one or more of these signs within a corporation does not mean necessarily that fraud is underway or contemplated. Rather, the existence of such factors should present those who are charged with corporate fraud risk mitigation with some food for thought.

The Chief Executive Officer (CEO) Is a Narcissist

A narcissist is a person with an excessive amount of self-interest. The word is of course derived from the mythical figure of Narcissus, the young man who fell in love with himself when he saw his reflection in a pool.

In a corporate setting, the narcissist is alternately a bully and charming. Generally, the corporate underlings will receive the bullying treatment while the charm is turned on for those who may be of use to her or him. The narcissist CEO has a “disguised and distorted will to power” according to the Austrian psychologist, Alfred Adler.

A more recent writer on this topic, Dr. Sam Vakin, goes into more detail when describing the possible attributes of the narcissist CEO. They are:

• A lack of empathy
• The centrality of the façade of wealth and social status
• A need to uphold a “false self”
• The use of shortcuts to bridge the “grandiosity gap”

These are the character factors which can lead to fraud.

Of course, few CEOs of public companies are shrinking violets; the nature of the job is such that it attracts type-A personalities. Still, there is a wide gap between a robust leader and a pathological narcissist. It is the latter's conduct we need to worry about.

The CEO Takes a Keen Interest in Basic Accounting Entries

In my experience, there are two types of CEO: accountants and non-accountants.

Accountants who become CEOs invariably start at the bottom of the financial hierarchy, either as students (who sometimes see themselves as financial galley slaves) at audit firms or as accounting trainees toiling away in the bowels of the corporation. From these lowly positions they work their way up through supervisor, manager, assistant controller, controller, vice president finance, chief financial officer, until a very few reach the pinnacle appointment of CEO. There has been a lot of adding up and staring at debits and credits on the way up. By the time accountant CEOs reach the top they will generally have had their fill of basic accounting. As CEO, they are interested in strategy and big-picture issues. They are ultimately responsible for everything, including sales, marketing, risk management, future direction, human resources, and yes, financing.

Non-accountant CEOs have the same comprehensive level of responsibility but they have not had to concern themselves with a focus on debits and credits on their way up to the top. Why would such a non-accountant CEO suddenly develop an interest in basic accounting upon being appointed to the top job?

The questions we have to pose when we notice either type of CEO having regular meetings (especially of the closed-door variety) with junior finance employees are: What is going on? Why would either type of CEO have a legitimate interest in monitoring the work of colleagues outside of the C-suite, particularly those who work at the bottom of the financial pyramid?

The concern here is that the CEO may be manipulating the numbers and, of necessity, using junior colleagues to make the inappropriate entries to the books and records of the company to cover up some other financial reality.

This type of comprehensive financial manipulation is always a conspiracy led from the top. Accountants have coined the expression “tone at the top” to describe how the moral landscape of a corporate entity is determined by the CEO. When the boss is corrupt, the rot spreads downwards.

The Company's Operation Represents One Person's Vision

It takes vision and a lot of drive to start your own company. Once a business grows, more help will be required. Sometimes, problems emerge if the entrepreneur insists on doing things her or his way. The founder may take shortcuts and ignore the warnings of others. This can lead to abuse or fraud.

A healthy corporate culture develops over time and is the product of many minds. If one examines long-established public companies, the common factor is that the culture is a composite. For example, Canadian banks and insurance companies, once established, tend to be around for a long time. They all have vision statements, but this is a corporate vision; you do not see the mind of a single individual at work. This is the reason why companies such as Hudson's Bay Company (established 1670) and BMO Bank of Montreal (established 1817) have been around for a long time.

The Corporate Organization Chart Does Not Reflect Reality

A corporate organization chart is a map to reporting structures within the corporation. It is generally a pyramidal shape with the CEO at the apex. It is important for everyone to know their place inside this metaphorical pyramid. Sometimes, reporting responsibilities become complicated when an individual has two or more supervisors: This leads to “dotted-lines” of responsibility. This should not be a problem; what is a problem is when the organization chart does not reflect the reality of the corporate organization, when employees actually report to someone other than their designated supervisor.

The risk of fraud is greatest when the financial function is subverted. If the person with the title of chief financial officer (CFO) is not in fact fulfilling that function, we have to pose the question: What is going on? It may be that there are two sets of books: one reflects reality; the other reflects a concocted set of numbers designed to deceive financial statement users and the auditors.

Perhaps a more junior person is calling the financial shots; perhaps a third-party consultant has been brought in to do the job; perhaps the CEO is doing everything. Whatever the case, if the CFO as defined in the organization chart is not the real CFO, it is not good. Remember that the hallmark of fraud is deception: This dictum does not just apply to covering up individual fictitious transactions; it applies equally to deceit applied to corporate organization charts.

The Board Does Not Understand All Aspects of the Business

When a corporate board does not have a diverse array of talent and experience, the risk of misconduct by management and staff is elevated. Simply put, if the board lacks insight in some critical areas of the business, it cannot provide the type of adequate oversight that the shareholders or other stakeholders expect.

A common example of this type of board failure is sometimes seen in not-for-profit industry associations where board membership is restricted to sector practitioners, for example, engineers, physicians, or lawyers. These people are experts in their own area of practice; they are often chosen to provide geographical representation as opposed to corporate expertise. Such unbalanced boards invite fraud, waste, and abuse.

To take another example, consider financial entities which have been damaged or destroyed by “rogue traders” who go off on a derivative frolic without adequate supervision. Yes, management will be blamed for allowing this type of misconduct to happen, but one is often left with the impression that the board overseeing this type of activity did not know what was going on and that there was no one director who understood how derivative instruments work and who understood the enormity of the risk.

It is generally accepted that a better business model consists of a diverse board with representation by gender and minority groups so as to reflect the community that the entity serves. It is no less true that the board should have a diverse roster of ability in areas such as sector experience, sales, marketing, human resources, finance, law, regulatory compliance, and so forth.

The Minute Books Are Not Up to Date

The minute books of a corporation provide a permanent record of important decisions and major transactions. Traditional minute books are hardbound tomes with prenumbered lined pages. They are kept locked up in a fireproof safe and see the light of day only when they are being updated or when the auditors are examining them (auditors invariably scrutinize the corporate minute books as part of their annual review, so important is this record to allow a complete understanding of corporate activity).

Nowadays, corporate records are usually online, but minute books are still among the last records to receive the digital treatment. Whatever medium is used for maintaining the minute books, an incomplete record is not a good sign. It may be that a corrupt senior management team does not want to be caught in inconsistencies, so it leaves the permanent record blank. It is also relevant to consider that the corporate secretary charged with keeping the minute books up-to-date may be a lawyer who has a professional credential and a personal reputation for integrity to consider. This professional may not want to impugn her or his character by knowingly being associated with false statements.

The Audit Committee Is Inactive

An effective audit committee has the following attributes:

• It is independent of management.
• It meets regularly.
• The members are financially literate.

Current regulation in the United States and Canada prescribes a set of rules for members of audit committees. It would be unusual nowadays to find too many inactive audit committees associated with public companies subject to regulatory oversight.

The risk is greater in the private and not-for-profit sectors where talent may be thinner on the ground and where a regulator is not keeping an eye on things.

An effective audit committee supervises the activities of the auditors but also monitors the financial well-being of the corporation. An audit committee stacked with cronies of management, none of whom are accountants or persons with some type of financial expertise, and which does not meet regularly, cannot fulfill the function for which an audit committee is intended.

It is also relevant to note here that when a large fraud occurs at a company, it is common practice to hire an external forensic accountant to carry out an investigation. A special committee will be struck to supervise this investigative process. More often than not, the special committee and the audit committee are one and the same: An ineffective audit committee will normally be a similarly ineffective special committee.

Senior People Have a Flamboyant Lifestyle

No one expects the CEO and senior executive management to take vows of poverty. This group is well-paid; they are entitled to enjoy the fruits of their labor—up to a point.

An overly flamboyant lifestyle may point to two concerns:

1. Senior people are millionaires who are trying to live a billionaire lifestyle.
2. Too much time is being spent on fun and not enough on minding the business.

If a senior executive is living beyond what an observer might think a C-suite person can reasonably afford, the questions to ponder are: Where is the money coming from? Has someone won the lottery or been named as a beneficiary by a wealthy relative in a will? Alternatively, is the corporation making large loans which are hidden or unauthorized? Are operations being set up in exotic locations more for the enjoyment of senior people and less for business purposes? Are we looking at old-fashioned embezzlement?

Senior people at large corporations do not clock-in at 9:00 a.m. and clock-out at 5:00 p.m. Theirs is generally a time-consuming life where a major challenge is commonly achieving a work/life balance. Everyone deserves a vacation, but a CEO or other senior executive who spends too much time on activities such as regular golf trips to Ireland and Scotland or sailing the 80-foot yacht around the Virgin Islands may be selling the corporation short. White-collar criminals live a life of deception: It is not relaxing knowing that any day you may be found out. Spending time away from the office when you should be working may offer a temporary sense of relief.

Noncore or Unusual Business Activities Generate High Revenue

Long-term systemic manipulation of the financial statements designed to cover up fraud does not last forever. At some point, the cash runs out. When that happens, the corporation cannot meet the payroll and is out of business.

Noncore or unusual business activities may herald a last desperate search for cash. It is not a good sign. Here are some examples:

• Factoring accounts receivable. Accounts receivable are sold to a third party who undertakes to collect them and assume the risk of bad debt losses. This accelerates cash flow for the vendor, but it comes at a high price.
• Bill-and-hold sales. The inventory is billed (thereby creating a sale) but the inventory remains on site at period-end (thereby reducing cost of sales if it is not removed—as it should be—from the financial records).
• Round trips. Inventory is sold close to the year-end. The compliant purchaser returns the inventory after the year-end. This reduces sales in the subsequent period, but it has allowed the vendor to jack up sales in the earlier period, which may give the corporation a little more breathing space and more leeway from lenders.

There are many more examples. The list of shady transaction schemes is limited only by the imagination of the perpetrators.

It should also be noted that factoring, bill-and-hold, and conditional sales contracts (allowing the right of return) are quite legitimate if done in the normal course of business and if properly recorded. It is when they suddenly pop up outside the usual pattern of business activities that we may be concerned that all is not as it should be.

The Corporation Is Not a Securities and Exchange Commission (SEC) Registrant

Some may say that it is a bit of a stretch to suggest that corporations not regulated by the SEC are more susceptible to fraud. However, in assessing fraud risk, a consideration of the role of the regulator is central. To put it simply, the SEC carries a bigger stick than other regulators.

If an SEC registrant is found guilty of fraud or misconduct, the amounts of fines imposed on the errant corporation can be gargantuan. Regulators in many countries are routinely criticized for being too lenient on the individuals behind fraudulent schemes. Still, American courts regularly send white-collar criminals to serve terms in imprisonment much longer than might be the case in other jurisdictions.

The reach of the SEC is extraterritorial. That is because the SEC regulates all corporations which are publicly quoted on American stock exchanges. Roughly 10 percent are foreign registrants, including many Canadian corporations.

It is instructive to compare the regulatory regime in Canada and in the United States. Canada has 13 securities regulators (one for each of the ten provinces and one for each of the three territories); the United States has one regulator: the SEC. Obviously its investigative resources are much more powerful. The SEC is much tougher in handing out severe penalties. If you are a person contemplating embarking on a career of financial manipulation, the specter of the SEC out there as your regulator may give you pause, more so than if you are regulated by a smaller, less aggressive government agency.

It is possible to level a critique at the suggestion that the SEC is the most rigorous regulator, by pointing out that we seem to read more about U.S. financial scandals in the newspapers than we do Canadian scandals. This is to overlook the fact that America's corporate sector dwarfs Canada's; the entire Gross Domestic Product of Canada is, after all, less than that of the state of California.

Conclusion

How does a recognition of these tell-tale signs help us? The board may not be close enough to day-to-day operations to spot these indicators, but frontline employees are in a position to have the initial inklings of inappropriate corporate behavior. They will be first to notice potential indicators of fraudulent activity before it becomes apparent to other stakeholders. Fraud occurs over time; the sooner light is shed on bad behavior, the sooner the problem can be remedied. In extreme cases, where the fraudulent activities proceed unchecked, the final outcome may be the bankruptcy or other demise of the corporation.

The most powerful tool currently available to mitigate fraud risk when other internal controls have failed is the implementation of a corporate mechanism to facilitate upstream communication—in simpler words, the introduction of a whistleblower regime. If well-crafted, this makes it easier for an employee who suspects fraud—who has seen some tell-tale signs—to speak up while at the same time protecting the whistleblower from retaliation. This whistleblower mechanism has been required practice for public companies since the implementation of the Sarbanes Oxley reforms in the United States and similar legislation in Canada. It is the best early warning system available to the board of directors to shed light on financial wrongdoing at a stage earlier than might otherwise occur.

About the Author

James Hunter is a forensic accountant. He is a part-time course director in the Faculty of Liberal Arts & Professional Studies at York University.

Following qualification as a chartered accountant in London (England), he joined the Toronto office of KPMG LLP. After being elected to the partnership, he was appointed as president of KPMG Forensic Inc. and head of Risk and Compliance Services (Ontario and Atlantic). He has carried out investigations and fraud risk assessments in Canada, the United States, the United Kingdom, the Netherlands, Germany, India, South Korea, Hong Kong, and Thailand.

He obtained his undergraduate degree in English Language and Literature from Edinburgh University. This may seem like an odd educational background for an accountant. However, for an investigative accountant whose reports may form the basis of energetic cross-examination by civil and criminal defense counsel, it has proved to be relevant and helpful. The use of clear writing and the avoidance of careless or loose language in a report placed before a judge is just as important as the ability to make sure the numbers add up.