Misconduct and fraud are very real problems in all companies today. But how do you define exactly what fraud is. Does fraud consist simply of misappropriation of assets or does it also include misconduct and corruption within an organization?

Since Sarbanes-Oxley was passed, many types of fraud have come to light including the college loan fund scandal and corporations reporting internal fraud. “Fraud is an intentional deception that drains value from an organization,” says Timothy Hedley, Ph.D./CPA, Partner, KPMG. Hedley was joined at a recent AICPA Webcast on corporate fraud by Neil Weinberg, Senior Editor at Forbes Magazine, Walter Pavlo and Greg Farrell, Investigative Reporter for USA Today. In the U.S., CEO pay is often directly related to the number of options rewarded. “This sometimes can create a much bigger incentive to cut corners and push things a little further than they should be,” quipped Weinberg.

Fraud occurs at companies of all sizes. is In smaller companies, the controls are looser at the rank-and-file level, and this leads to pilfering and embezzlement. On the flip side, at the larger companies it is “more difficult to police or patrol everything, especially in far-flung operations,” said Farrell.

KPMG’s Forensic Integrity Survey 2005-2006

KPMG, with the help of outside research firms, recently conducted a nationwide survey on fraud over a 12-month period, spanning all levels of job responsibility. The objective of the survey was to provide a look at corporate fraud and misconduct both pre- and post-Sarbox. Nearly three out of four of over 4,000 survey respondents said they had observed misconduct in their organizations during that period, while more than half noted that they had seen serious misconduct in their firms that could cause “a significant loss of public trust if discovered.” Surprisingly, most of the respondents were from the middle-market area and belonged to the grass-root sector within the company.

Looking at prevalence of misconduct during the prior 12-months versus prevalence of misconduct that could cause a significant loss of public trust if discovered, both pre-Sarbox and post-Sarbox received high marks. Survey respondents noted prevalence of misconduct 74 percent of the time post-Sarbox era, while prevalence of misconduct that could cause a significant loss of public trust if discovered, was split down the middle at 50 percent in 2005, and 49 percent in 2000.

Experts noted that nothing has really changed from 2000 to 2007 in terms of fraud. However, the perception of it has probably changed and people are more aware of fraud in the workplace because of training and communications within companies. There seems to be a higher sensitivity towards fraud. “People recognize when fraud takes place early on,” said Pavlo, more so now than five to six years ago.

Prevalence of Misconduct by Industry During the Prior 12 Months

“Surprise, surprise, where there’s money, there’s a way,” chimed Weinberg. Not surprisingly, public sector came in as the top contender at 81 percent. “Public sector is the nexus of all problems,” said Weinberg. “You’ve got underpaid public officers, political corruption, all the business interests and the revolving doors with the lock in the industry, so you have the worst of all the worlds and so this is not surprising!” The healthcare industry, which has become synonymous with fraud in Medicare, Medicaid and corporate, came in at 75 percent. And despite the strict regulations that the Banking and Finance industry abides by, they came in at 68 percent.

Root Causes

There are three important clauses to fraud. According to Hedley, for fraud to exist in a company, there needs to be three elements. He called this the Fraud Triangle. This triangle includes:

• Opportunity. Conditions have to exist.
  
  
• Incentive or Pressure. The opportunity has to present itself.
  
  
• Rationalization. One has to justify the behavior. This in itself is a great red flag.

Although Hedley noted that the third point in the triangle is the hardest for most because it is not easy to rationalize that when you’re committing a fraud that it is the right thing to do, Pavlo opposed the notion. As a former fraudster, Pavlo said that those who work in the sales force always have to meet a number and they are under extreme pressure each quarter to meet that target. If you have a salary, it’s not that much of an issue. But when you’re in sales, your “income is based on sales incentive,” and that’s when people crack. “It’s easiest to measure a number,” said Pavlo. “People get innovative in order to meet that number. They start thinking out of the box. Numbers are of the utmost importance,” he added.

Another undetected fraud comes from the tone-at-the-top. “People at the top are given a higher level of tolerance than others,” said Pavlo, “which sets a bad precedence.” Although this happens a lot, it does not set a good example to the rest of the organization.

Solution?

Communicate, communicate, communicate. Communicating to employees is a company’s commitment to ethical behavior. “We communicate top down,” said Hedley. “The problem lies in that the people communicating the ethical behavior have to perform that way, they have to demonstrate their own behavior in that way,” he added.

Another way to solve the situation is to take to task those same high-level individuals who commit the fraud. Pavlo shared an example of how Wal-Mart had once discovered a high-level executive committing fraud and that they did not give the person a second chance. They fired the person and showed their employees that all staff was treated equally where misconduct and fraud was concerned. And that is the road all companies should follow.

Last Words

“Where there’s smoke, there’s fire,” said Farrell, “even if some fraud seems to be small or behind a firewall where they couldn’t hurt their company, if there is corruption or fraud in one part of an organization, you can easily migrate it to other parts of the firm,” he added. Almost all companies are subject to fraud and misconduct, but it is the “hidden crime, which is the real problem,” said Hedley. “It is the intention to deceive.” And what does Pavlo have to say about all this? Having committed a white-collar crime for which he spent two years in a federal prison, Pavlo says, “Tone is set by individuals … personal responsibility towards ethical behavior is of utmost importance no matter at what level you’re at.”

Sukanya Mitra is Managing Editor of the AICPA's Insider™ electronic newsletter group.