Who’s watching for accounting fraud?

The U.S. Securities and Ex- change Commission’s new chair, Mary Jo White, wants to return the agency to its task of policing corporate financial filings, say reports. The numbers show the commission took a break from that mandate to deal with the financial crisis: cases handled by the SEC involving financial fraud and issuer disclosure in 2012 dropped to about one-third of the level seen in 2007, before the liquidity crunch.

After witnessing how easy it is for corporate management to manipulate accounting rules and financial results, advisors often ask how much protection the board of directors or the financial statement auditors really provide.

Investors shouldn’t rely much on those financial caretakers (see “Global fraud goes undetected,” this page). Why is only a small proportion of fraud discovered? Auditing rules are not designed to protect against fraud. In fact, an auditor relies significantly on management input to direct the course of an audit.

For instance, related-party transactions are a major arena for committing frauds (see “Monitor related-party transactions to shield clients,” Advisor’s Edge Report, Dec. 2011). Audit rules only direct auditors to ask management to list its related parties. If management leaves someone off, it’s rarely considered the auditor’s responsibility to find those undisclosed parties or to actively seek out potential fraud.

A forensic audit is something different. These are usually launched at the behest of the board when a scandal erupts in the public eye. Investors tend to hold the mistaken belief that a financial statement audit proactively looks for financial shenanigans the way that a forensic audit would. But a normal financial statement audit is only designed to provide reasonable assurance the documents are free of material misstatements. This is done by testing a small amount of transactions. Auditors are generally discouraged from digging around for potential management deceit.

A further limitation is imposed by the accounting rules themselves. Under Canadian rules, audits tend to test the financial statements within the scope of International Financial Reporting Standards, which have been proven to give management significant leeway in reporting financial results.

Complacency of boards

When it comes to openly accepting accounting manipulation, some board members look the other way. A May 2013 fraud study from accounting firm EY surveyed more than 3,000 directors and managers in 36 countries. One in five respondents said they had seen financial manipulation occur in their own companies. This compares to another study that also pegged the prevalence of manipulation at 20% but those respondents were only asked if they thought the manipulation occurred at other companies, and not their own (see “Uncovering accounting irregularity,” Advisor’s Edge Report, Dec. 2012). The EY study found the incidence of manipulation was even more widespread in higher-growth countries, as a result of a perceived pressure to keep pace with peers. It also revealed financial manipulation is the norm for the majority of companies in some countries, including 54% in India and 61% in Russia.

Global fraud goes undetected

A report from the Association of Certified Fraud Examiners, which looked at global fraud in 2012, found companies lose 5% of total revenue to fraud; worse, financial statement auditors don’t usually prevent such significant losses. While external audits were the most commonly used fraud control at the companies surveyed, those reviews detected just 3% of frauds.

It doesn’t seem increased regulation has stamped out manipulation. In the financial services sector, which has seen significant scrutiny over the past several years, 9% of respondents reported seeing false revenues being recorded, 7% witnessed the under-reporting of expenses, and 9% knew of customers being sold unneeded products to boost short-term sales results.

With management able to easily manipulate financial results when so inclined, auditors catching an insignificant proportion of frauds, and boards that seem complacent when needed most, investors are putting unreasonable reliance on securities commissions to catch all the misdeeds.

The SEC is only now starting to get back into the game after the financial crisis started five years ago, and the message is that the resources of securities commissions are stretched, allowing frauds and financial misstatements to go unnoticed. In Canada, provincial commissions have a poor record of identifying cases of misleading financial reporting, often relying on their U.S. counterparts to do the heavy lifting.

So advisors need to do some work. Aside from analyzing companies’ financial statements, also consider qualitative factors.

Geography can be a major risk factor, with companies based in China, Russia, India, Africa and Oceania on top of most warning lists. This includes focusing on where the operations and assets of the company are located (not just where the shares are domiciled). Sino-Forest, for instance, had its assets in China while being listed here in Canada.

While lax accounting, auditing and regulatory oversight can represent the means for fraud and manipulation, advisors should also be mindful of motive. Experience shows the most serious misstatements are usually accompanied by flawed executive compensation schemes. Investors should watch for companies that rely on non-GAAP/non-IFRS measures to support their stories. An even bigger red flag is when executives change horses mid-race, switching away from one non-GAAP measure to another when the first stops producing the desired results.

There can be positive indicators too. While external audits catch just 3% of global frauds (and less than 2% in Canada), tips from whistleblowers are the most successful method, identifying 43% of fraud cases. A whistleblower hotline increases the chances that a fraud will be detected, and detected sooner. Therefore, companies with strong internal whistleblower policies (like what SNC-Lavalin Group has implemented in the past year) have a lesser chance of falling victim to financial fraud, reducing investor losses in the process.

Dr. Al Rosen, FCA, FCMA, FCPA, CFE, CIP and Mark Rosen, MBA, CFA, CFE run Accountability Research Corp., providing independent equity research to investment advisors across Canada.