The Association for Certified Fraud Examiners (“ACFE”) conducted a global fraud study, which investigated 2,410 cases from January 2014 to October 2015.[1] The study focused on many types of fraud, but emphasized the incidence of internal fraud within the organizations. Accordingly, this post will discuss the costs and prevalence of internal fraud. It will then discuss potential solutions to mitigate its consequences, such as enforcing a new DOJ initiative and using blockchain.
Generally, corporate fraud occurs when an individual or company engages in dishonest or illegal activities that are designed to provide the perpetrating individual or company with an advantage.[2] Generally, there are two types of fraud: internal and external fraud.[3] Occupational fraud falls within the former and is the “use of one’s occupation for personal enrichment through the deliberate misuse or misapplication of the organization’s resources or assets.”[4] The three main types of occupation fraud are asset misappropriation, corruption, and financial statement fraud.[5]
In the ACFE 2016 Global Fraud Study, asset misappropriation occurred in 83% of their case studies, but only accounted for $125,000 in losses.[6] In contrast, financial statement fraud occurred in less than 10% of case studies, but resulted in a median loss of $975,000.[7] Unsurprisingly, anti-fraud controls are “correlated with both lower fraud losses and quicker detection.”[8] However, not all anti-fraud controls are effective. The study found that 82% of the organizations where fraud was detected had underwent external audits from independent audit firms.[9] This type of anti-fraud control detected less than 4% of fraud.[10]
A recent, and significant example of internal fraud occurred in the Theranos debacle. The Securities and Exchange Commission (“SEC”) brought “massive fraud” charges against Theranos’s CEO, Elizabeth Holmes.[11] Specifically, Theranos “exaggerated or made false statements about the company’s technology, business and financial performance.”[12] Similarly, the SEC found that Homex, a Mexico-based construction company, “inflated the number of homes sold during the three-year period by approximately 317% and overstated its revenue by 355% (approximately $3.3 billion).”[13]
Given the extensive costs of internal fraud, potential solutions are needed to mitigate its consequences. Following Enron and WorldCom, the methods used to prevent corporate accounting fraud have vastly changed.[14] Now “independent auditors discover misstatements in financial statements” and relay this information to managers and audit committees.[15] Auditors then “evaluate the nature and materiality of misstatements and make decisions prior to issuing the financial statements.”[16] Despite these changes, financial statement fraud and asset misappropriation are still prevalent.[17] Furthermore, auditing companies and their financial statements are often inaccurate.[18]
The Department of Justice (“DOJ”) has promulgated the Corporate Enforcement Policy (“policy”), which “affords a presumption of declination if a company … voluntarily self-discloses misconduct, fully cooperates, and timely and appropriately remediates.”[19] Pursuant to the policy, Barclays has voluntarily disclosed their transgressions and cooperated with the U.S. government.[20] However, while this method has proven successful in the past, this is an informal policy. The DOJ has not explicitly enforced this method for preventing corporate fraud in the U.S.[21]
Blockchain can offer a more concrete fraud prevention method. Blockchain “decentralizes system management and authorization to a network of computers,” which “verif[ies]transactions based on certain pre-specified rules (controls) that have been embedded in the system.”[22] By tracking every asset transaction, blockchain prevents “illicit changing or deleting of official accounting records” and can find any type of misappropriation.”[23] A more immediate and realistic solution may be to create a fraud hotline within the organization. Tips are “consistently and overwhelmingly the most common method” by which fraud is detected.[24]
Although solutions in fraud prevention have vastly progressed since Enron and Worldcom, policies that encourage self-disclosure and the use of blockchain can help prevent the loss millions of dollars for companies. While it may not be feasible to implement these solutions in the immediate future, a simple system like a hotline can still have a major impact in preventing fraud.
[1] See Report to the Nations on Occupational Fraud and Abuse: 2016 Global Fraud Study, Ass’n of Certified Fraud Exam’rs (2016) https://s3-us-west-2.amazonaws.com/acfepublic/2016-report-to-the-nations.pdf [hereinafter ACFE Global Fraud Study].
[2] See Corporate Fraud, Investopedia (2018), https://www.investopedia.com/terms/c/corporate-fraud.asp.
[3] See What is Fraud, Ass’n of Certified Fraud Exam’rs (2018), http://www.acfe.com/fraud-101.aspx.
[4] Id.
[5] ACFE Global Fraud Study supra, note 1.
[6] Id.
[7] Id.
[8] Id.
[9] Id.
[10] Id.
[11] See Pete Schroeder, Theranos and Its Founder Settle U.S. Fraud Charges, Reuters Mar. 14, 2018, https://www.reuters.com/article/us-theranos-sec/theranos-and-its-founder-settle-u-s-fraud-charges-sec-idUSKCN1GQ2HC.
[12] Id.
[13] See Press Release, U.S. Sec. & Exch. Comm’n, SEC Charges Mexico-Based Homebuilder in $3.3 Billion Accounting Fraud Date, available at https://www.sec.gov/news/pressrelease/2017-60.html.
[14] See Fatima Alali & Sophia Ling Wang, Characteristics of Financial Restatements and Frauds: An Analysis of Corporate Reporting Quality from 2000–2014, CPA Journal, Nov. 2017, https://www.cpajournal.com/2017/11/20/characteristics-financial-restatements-frauds/.
[15] Id.
[16] Id.
[17] ACFE Global Fraud Study supra, note 1.
[18] See Wiseman Nkuhlu, Public Interest A Vital Element in Auditing, Business Day Opinion, Mar. 22, 2018, https://www.businesslive.co.za/bd/opinion/2018-03-22-wiseman-nkuhlu-public-interest-a-vital-element-in-auditing/.
[19] See Thompson Hine LLP, DOJ Officials Signal Expansion of Voluntary Self-Disclosure Incentives Beyond the FCPA, Lexology, https://www.lexology.com/library/detail.aspx?g=31de1116-cff6-41e3-a302-9b468b73b9f3.
[20] Id.
[21] Id.
[22] See Jun Dai, Yunsen Wang and Miklos A. Vasarhelyi, Why Blockchain Has the Potential to Serve as a Secure Accounting Information System, CPA J., Sept. 2017, https://www.cpajournal.com/2017/09/20/blockchain-potential-serve-secure-accounting-information-system-cpe-season/.
[23] Id.
[24] ACFE Global Fraud Study supra, note 1.
