Why can’t accountants prevent fraud?

Philip Maguire, CPA, CA, is a principal at Glenidan Consultancy Ltd. His practice focuses on internal controls over financial reporting for a number of publicly listed companies on the Toronto Stock Exchange.

THERE is more depressing news in the white collar crime front. The two principals in the Bonfield Construction Company fraud in Toronto have been sentenced to lengthy jail terms (they are appealing their convictions). The founder of Reid’s Heritage Properties in Guelph is defending himself against several civil suits claiming that he orchestrated a $75 million to $100 million Ponzi scheme. And the Toronto Star revealed that two Toronto accountants have lost their accounting licences as a result of court actions alleging that they created a Ponzi scheme. 

Why are there so many instances of corporate malfeasance in the workplace and, more importantly, what can the accounting profession do to protect the investor and the public? 

Despite the range of fraudulent activity, it doesn’t take long to spot similarities amongst frauds 

What is most upsetting about frauds is how obvious the warning signs are in hindsight. Can we learn anything about these indicators in order to predict unethical behaviour? 

Almost every significant fraud involves the principals of the organization. When you are the boss it is easy to break the rules. The boss’s word is the final word. Even when staff are suspicious it is too difficult to confront the owner/ President. 

And why is it easy to steal money? Because the senior people are at the highest risk of conflict of interest. A conflict of interest arises when a person derives personal benefits from their official capacity, or two or more parties collude to derive personal benefit. 

Another problem is that fictitious financial statements or appropriated assets often originate in the operations of the company. The accountant, as preparer of financial statements, is usually far removed from the front line or operations. 

So let’s examine three processes where the accountant can add value to the organization in preventing or detecting fraud.  

What can the accountant do? Design appropriate hiring practices 

One of the best means of preventing conflict of interest is to rely on the ethical compass of those in charge. But this is difficult to assess. Unfortunately the only time to evaluate a person is during the hiring phase; but that is when you know the least about the employee. We often see the same bad apples surfacing at another company. Muddy Waters Research LLC has made a name for themselves with their short selling strategy. They identify leaders at their target companies who have controversial backgrounds.  Muddy Waters believes that once a fraudster, always a fraudster. 

The accountant should be involved with the Human Resources department when designing background checks for senior staff hires. For example, the organization should be investigating new hires for poor credit scores, personal bankruptcies, participation in civil or criminal lawsuits, penalties from their profession bodies or regulators and unfavourable press coverage.

So what can the accountant do? Reconcile Management’s results to independent sources 

Accountants are not doing a good job of verifying, or reconciling, the financial results to independent sources. Accountants that perform a bank reconciliation struggle to extend this logic to other aspects of financial reporting. Reconciliations are the most effective means of detecting fraudulent, or inaccurate, reporting. This process will take on more importance with the emergence of Artificial Intelligence as I outlined in a previous article. 

It is a recurring story — the financial results are far removed from reality and no one is paying attention. The Bernie Madoff Ponzi scheme fooled investors into believing that his financial prowess could out-perform the stock market. Mr. Madoff published inflated returns purportedly from stock market indices to hoodwink his victims.

The fraud was eventually uncovered in 2009, a year after the global financial crisis of 2008, when every firm but Mr. Madoff's was reporting poor returns. However, in 2002, an analyst from a competing firm was paying attention. Mr. Harry Markopolos reconciled Madoff’s returns to the stock market indices and realized that this was a Ponzi scheme. Despite many attempts to alert the Securities and Exchange Commission this analyst’s warnings were ignored. 

So what can the accountant do? Be brave 

When it comes to detecting fraud there are some themes that explain the disappointing performance of the accountant. The three most prevalent issues are:

1. Someone else is responsible for detecting fraud; anyone but you. You believe it is the responsibility of your boss, the auditor, a regulator, other management members and so on. If you take the perspective that nothing will get by you then you have a better chance of performing well. 
2. A lack of confidence in your abilities. You may feel that you are too junior, not experienced or not sure you will be taken seriously. Focus on the facts to dictate your performance and not what you believe others think of you. 
3. You are too ready to accept explanations for the red flags. To quote Mr. Harry Markopolos “As analysts we are taught to look for red flags. That’s not true. You find one red flag, that’s enough”. A good accountant challenges what they are being told. You must verify management’s explanations and pursue your investigation until you are satisfied with the result.         

There is no question that fraud prevention and detection are challenging issues. As a profession however we can, and must, do better. 

Philip Maguire, CPA, CA, is a principal in Glenidan Consultancy Ltd. His practice focuses on internal controls over financial reporting for a number of publicly listed companies on the Toronto Stock Exchange. Philip teaches a number of CPD (continuing professional development) courses in Canada, England & Wales and Ireland. Title image: iStock ID 103060159.