From Main Street to Wall Street, the impact of new corporate-governance regulations has been felt throughout the business world. Well-publicized instances of financial reporting fraud scandals and the collapse of a number of major corporations shook the financial markets and investor confidence.
These events gave rise to the most dramatic corporate reform in 70 years, including the Sarbanes-Oxley Act, revised federal sentencing guidelines and other mandates. Yet, despite these changes, the threat of fraud remains a significant hazard that could ruin a company’s finances, damage its brand and reputation, and send it down into a death spiral of government investigations, loss of market cap and bankruptcy.
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Reported fraud remains on the rise according to a recent survey by KPMG LLP, the audit, tax and advisory firm, of more than 450 companies, and from state and federal government agencies. While reported fraud is increasing, the survey also indicated that organizations have countered with new detection and prevention measures.
Not surprisingly, the survey found that while financial-reporting fraud is not the most frequently occurring fraud, it represents the greatest threat to a company’s bottom line, followed by medical/insurance fraud.
Illicit financial-reporting activity such as the overstatement or understatement of revenue or expenses has contributed to the financial turmoil plaguing a string of companies. In the survey, financial reporting fraud more than doubled to 7 percent of all reported fraud since a similar survey in 1998. It is by far the most expensive type of fraud at an average annual cost of more than $257 million. Medical/insurance fraud costs organizations some $33 million annually.
Fraud is not a new phenomenon. Companies of all sizes always have been vulnerable to the threat of many types of fraud and misconduct, ranging from more prevalent transgressions like misappropriation of assets to large-scale misdeeds such as financial-statement deception by senior management. What has changed, however, is the degree of awareness that companies have toward this pervasive threat – as well as its impact upon a company’s bottom line.
The KPMG survey found that 75 percent of respondents reported that they uncovered fraud in their organizations in the past year, compared with 62 percent in a 1998 survey.
Has the level of corporate fraud increased in recent years? While an increase is certainly a possible explanation for these results, experience suggests a greater sensitivity to fraud may offer a better answer as companies increase efforts to detect it and act decisively to prevent it.
Employee fraud, meanwhile, continues to be pervasive, according to the survey. Some 60 percent of companies say they were victimized in the past year by employee misdeeds, such as payroll or asset theft and expense account abuse – almost twice the rate of the next-highest category, consumer fraud. Asset theft and expense account abuse more than doubled since the survey five years ago.
The KPMG survey also found that collusion between employees and outside third parties, such as a vendor paying kickbacks to a company employee to buy its product, is a growing problem. Almost half, 48 percent, of respondents cited collusion as contributing to fraud, compared with 31 percent in 1998.
Heightened awareness of fraud is just one factor driving increased fraud prevention and detection efforts. The impact of Sarbanes-Oxley and other regulatory requirements, the need to maintain investor confidence and a greater focus on fraud by boards and audit committees have driven companies to look for ways to improve fraud risk management controls, processes and programs and have all contributed to a cultural change in how organizations respond to the threat of fraud.
This change has occurred in many areas of business operations as corporate management strives to take concerted action to detect and prevent fraud and misconduct. Many businesses have revisited, or in other instances instituted codes of conduct that set forth the company’s commitment to business integrity combined with reporting channels such as employee hot-lines for reporting fraud or misconduct without fear of retaliation.
The KPMG survey indicates that businesses are taking positive measures in their accounting practices in response to fraud. Nowhere is the increase in companies’ anti-fraud response as dramatic as in the implementation of internal fraud-detection controls. More than three-quarters of companies surveyed – 77 percent – say they used internal controls as the chief means for uncovering fraud, compared with 51 percent five years ago.
The survey found a sharp increase in the use of internal audits – from 43 percent in 1998 to 65 percent in 2003 – as companies have upgraded the detection capabilities of their internal audit units and other aspects of their operations to address concerns about fraud. Further, they are responding to suspicions and allegations of fraud by initiating their own formal investigations – 98 percent of survey respondents say they did so, compared with 94 percent five years ago.
One way that companies have sought to upgrade their investigative capability is through the use of fraud-detection technologies. For example, forensic software that performs data analytics allow companies to sort through large volumes of data to search for anomalies – and red-flags of fraud more effectively and efficiently.
Many companies not only are more aware of and taking action against those who commit fraud, but also intend to take further action. Some 74 percent said they plan to launch anti-fraud initiatives in response to Sarbanes-Oxley, driven by stricter government-imposed regulations and penalties but also by a desire to practice good business ethics.
The fact that almost three-quarters of companies surveyed plan to take anti-fraud measures is encouraging. Viewed another way, however, this finding raises a concern for those companies that do not plan such action. Despite greater monitoring, more regulatory oversight and the growing trend of corporate-sponsored whistle-blower programs, more than one in five companies (22 percent) said they do not plan to implement new controls, even though many companies are still evaluating their internal controls as required by Sarbanes-Oxley.
As for the future, many more organizations than in previous surveys feel that fraud will decline with 43 percent of corporate and government executives predicting a decrease in fraud incidents in the next 12 months, and just 7 percent expecting an increase. This optimism is based largely on their belief in the effectiveness of their anti-fraud measures.
The increased awareness of fraud among companies of all sizes is a positive step forward. But there is a danger that misplaced optimism over current efforts could lead to a complacency that will result in reduced anti-fraud efforts in the future and increased vulnerability to fraud. Continued vigilance is key if companies are to maintain their momentum and build upon their success.
Patrick J. Canning is the office managing partner in Providence for KPMG LLP. Richard H. Girgenti is Americas partner in charge of the Forensic practice of KPMG LLP, and is based in New York.
