| Financial
Statement Complexity: A Breeding Ground for Fraud
SEPTEMBER
2006 - The corporate financial scandals in the early part
of this decade shocked our financial markets and will be
remembered for the carnage left by the likes of Enron and
WorldCom: thousands of workers robbed of their retirement
funds, millions of investors who lost their savings, and
the havoc wreaked upon our economic and social systems.
If we could only put it all behind us!
Unfortunately,
the complexity embodied in financial accounting standards
promotes a breeding ground for an endless variety of fraudulent
schemes.
The
more detailed the standards, the more loopholes in which
to seek opportunities for abuse. Each day I’m awakened
by the newscaster on my radio alarm clock talking about
another scandal that’s brewing, along with my fresh
morning coffee: the backdating of stock options for executive
compensation, the State Department shuffling overhead expenses
from one capital project to another to conceal cost overruns,
and so on.
The
reality that fraud isn’t restricted to any one sector
of our society is reinforced every time I read through another
pile of manuscripts submitted to the Journal. From large
publicly traded corporations to governmental agencies to
nonprofit organizations (is nothing sacred?) to small private
companies, fraud is everywhere.
Endless
Possibilities
Enron
remains an instructive example of how fraud can be perpetrated
by misusing the very standards and principles that are supposed
to protect the public’s interests. Amazingly, part
of why Enron’s management was able to keep their fraud
under the radar for so long was the complexity of the deals
and contracts they used to obfuscate the economic reality
of the company’s transactions. For example, special
purpose entities (SPE) were established for the sole purpose
of keeping the massive debt the company had accumulated
off of its balance sheet. Disguised loans, usually buried
in commodities or equities derivatives, were another scheme
that used complex transactions to hide illegal shenanigans.
Government
(fund) accounting is another ball game altogether. Some
might argue that in government there is no such thing as
accounting, because there are no profit-and-loss statements.
Governments, colleges and universities, and other nonprofit
entities present their financial information using statements
of activities, financial position, changes in financial
position, and cash flows. Governmental Accounting Standards
Board (GASB) standards also require budgetary comparison
schedules. Understanding the different format and focus
of fund accounting financial statements has proved to be
a challenge, however, even for many accounting professionals.
GASB cites the need for governmental accounting and reporting
standards different from those established for business
enterprises because “governments have a responsibility
to be accountable for the use of resources that is significantly
different from business enterprises.” Ironically,
the “use it or lose it” mentality that pervades
governmental agencies has been known to cause eleventh-hour
spending sprees.
Analogous
to the corporate world’s SPEs, “off-budget enterprises”
are commonplace in the government sector. Related entities,
such as boards and special districts, have been used in
the same manner as Enron’s SPEs: to keep certain transactions
off the books and away from public scrutiny. This practice
is what led to the near-bankruptcy of New York City in the
1970s.
Nonprofit
organizations provide financial information to the public
not through their audited financial statements but through
Form 990, an annual reporting return that is filed with
the IRS. As highlighted by an article published in last
month’s Journal, “Functional Expense
Reporting for Nonprofits,” appropriate audit and attest
standards are not applied to Form 990, leaving an enormous
opportunity for fraud. The United Way and Jesse Jackson’s
nonprofits represent only two of the more recent scandals
to rock the nonprofit sector.
Broadening
the Hunt for Fraud
While
large public corporations have garnered the most attention,
small and midsized companies with 100 or fewer employees
tend to be more vulnerable to fraud, according to the Association
of Certified Fraud Examiners’ (ACFE) 2006 Report
to the Nation. Asset misappropriations account for
about 90% of all occupational fraud and generate a median
loss of $150,000. In contrast, financial-statement fraud
occurs in only 10% of all cases, but the median loss for
this type of fraud is $2 million. That’s significant
enough to get most people’s attention.
While
large corporate fraud led to the reforms of SOX, its provisions
technically apply only to publicly traded corporations.
Private companies, governments, and nonprofits are not required
to implement SOX requirements that potentially reduce the
incidence of fraud. Regardless of legislators’ attempts
to reduce fraud, unless standards setters are able to simplify
our financial reporting framework and accounting standards,
financial statements will continue to be a breeding ground
for fraud and abuse.
As
always, I welcome your comments on these and other issues.
Mary-Jo
Kranacher, MBA, CPA, CFE
Editor-in-Chief
mkranacher@nysscpa.org
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