What constitutes accounting fraud?
It depends whom you ask. To an audit committee, it is financial representation, pure and simple. But to a securities lawyer, when such misrepresentation flows from an "altruistic" motive (for instance, to save a fledgling company, rather than financial gain), it could be hard to prove criminal liability.
Therein lies a conundrum, which can be explained by examining the so-called "fraud triangle."
Stopping fraud before it starts
Many organizations spend a great deal of time focusing on ways to prevent fraud before it occurs. Of the three sides of the fraud triangle—pressure,opportunity, and rationalization—the bulk of the effort over the last 15 years has gone to addressing the opportunity to commit fraud, primarily through internal controls. Such controls have been greatly fortified in recent years thanks to the 2002 Sarbanes-Oxley Act and the application of information technology.
Still, because fraud is the result of the intersection of human choices with system failures, it’s important to be wary of the false sense of security that internal controls, even well- designed ones, can bring. Collusion, and the ability of management to override controls, means that no system can fully prevent fraud. (For example, senior executives—those most likely to commit large-scale accounting fraud—are often well placed to collude with others and override such controls.)
What steps could you take to avoid rationalization—the slippery slope?
While pressure and opportunity can to a great extent be controlled by the organization, the element of rationalization is the wild card. That’s because it lives, not on a computer, or in a procedural manual, but inside the mind of a human being.
1. Accept the simple fact that rationalization is part of human nature, and that controls and other internal measures will never be 100% effective at stopping fraud. Once you work with that reality, potential solutions start to become clear.
2. Provide consistent training. If people clearly understand what constitutes unacceptable actions—and what are the consequences of taking those actions—it becomes that much harder for them to rationalize or justify fraudulent activity.
3. Having employees periodically sign certifications or other statements confirming that they have followed company protocols is another effective solution. Studies show that people are far less likely to lie if they’re given adequate time to prepare for the question, and if the question is posed in a non-confrontational way. This kind of regular day-of-reckoning exercise can be a powerful deterrent to the rationalization of bad behavior.