9 abuses conspired to create "perfect fraud storm"
As corporate scandals like Enron and WorldCom continue to shake out in the courtroom, many investors are still waiting for an acceptable explanation of how it all happened and how similar abuses can be avoided.
Noted Brigham Young University fraud expert W. Steve Albrecht has identified nine abuses that converged to create what he calls the "perfect fraud storm," in which CEOs and other high-ranking corporate officers perpetrated the largest financial frauds in history.
Published in the current issue of the "Journal of Forensic Accounting," Albrecht's pointed analysis of the causes behind the scandals provides government regulators, companies and shareholders with a better understanding of why the scandals happened and how to prevent reoccurrences.
"These were very significant problems that cost the average American a lot of money. You and I have money in retirement accounts, which lost significant value because of these abuses," said Albrecht, who will present his "storm" analysis to the U.S. Securities and Exchange Commission in September. "But there are things we can do about it so it will never happen again. This starts by understanding what caused the problems in the first place."
Joined by co-authors and sons, Conan, a BYU assistant professor of information systems, and Chad, a former BYU business student who graduated in April, Albrecht provides the following reasons for the recent business scandals:
The good economy of the 1990s and early 2000s brought about fraudulent behavior that was masked by apparent success. Several of the frauds, revealed since 2002, were actually committed during the boom years but went undetected. Executives misunderstood the reasons for success, attributing it to good management. When the economy went south, they may have felt increased pressure that led to fraudulent financial reporting and other dishonest acts.
Societal moral decay is rising, as evidenced by an increase in the number of high school and college students who admit to academic cheating and other factors. Although cheating doesn’t specifically address the behavior of CEOs, it may help partially explain why so many lower-level employees, aware of fraud, kept silent.
Misplaced executive incentives in the form of hundreds of millions of dollars in stock options or restricted stock made it far more important to keep the stock price rising than to report financial results accurately. In many cases, stock-based compensation far exceeded an executive's salary, so the attention shifted from managing the firm to managing stock price, which turned into fraudulently managing financial statements.
Wall Street analysts, who targeted only short-term behavior, drove share price movements by cementing expectations of the price of a company's stock. Executives knew that missing the "street's" estimate would result in considerable drops in stock price, a pressure that led them to misreport earnings.
Large amounts of debt and leverage of the companies involved placed tremendous financial pressure on executives to not only report high earnings to offset high interest costs but also to meet debt and other responsibilities. In 2002 alone, 186 public companies -- including WorldCom, Enron, Adelphia and Global Crossing -- with $368 billion in debt filed for bankruptcy.
U.S. accounting standard are much more rule-based than principle-based. If a client chooses an accounting method not prohibited by generally accepted accounting principles, it's hard for auditors to argue the client can't use that method. Rather than deferring to existing, general rules, executives exploited specific rules (or lack thereof), leading them into murky waters.
The opportunistic behavior of some accounting firms led them to use audits to establish relationships with companies to then sell more lucrative consulting services. Feeling little conflict between independence and opportunities for increased profits, some auditors, especially Arthur Andersen, lost focus and became business advisers rather than auditors.
Greed by executives, investment banks, commercial banks and investors caused them to ignore negative news and enter into questionable transactions. In Enron's case, various banks made hundreds of millions from the company's banking and derivatives transactions on top of tens of millions in loan interest and fees, but none alerted investors about Enron's underwriting problems. Also, major credit-rating agencies, which all received substantial fees from Enron, did nothing to alert investors of pending problems.
Educator failures, in the form of insufficient ethics training for students, left graduates ill-equipped to deal with the real dilemmas they faced in the business world. In one corporate scheme, 20 individuals, including most of a company's top management, were involved in earnings overstatements. Such a large number of participants points to a generally failed ethical compass. Albrecht, whose name graces the headquarters of the Association of Certified Fraud Examiners, stresses that any of these elements alone probably wouldn't have been sufficient to produce the scandals, but combined they became nearly inevitable.
"Each one is like adding another stick to a fire. The more you add, the hotter it gets. When the fire gets burning hot enough, you have an Enron or a WorldCom," said Albrecht, also a former president of the American Accounting Association. "If you take one of the sticks away, or several of them away, the fire is not quite as bright, not quite as big."
To date, some of the perfect fraud storm's fuel has been subtracted from the figurative fire, he said.
"The economy isn't as good, accounting rules are being reformed, accounting firms have restructured their operations -- these are all issues that have been addressed to some degree," said Albrecht, who in 2003 was named one of accounting's most influential people by "Accounting Today" magazine. "There's also been some progress in business schools to increase the number and quality of ethics and fraud courses."
Still, misplaced executive incentives, unrealistic Wall Street expectations, large amounts of company debt, greed and moral decay still exist and, in some instances, have worsened, he said.
"Everyone's asking, 'Has the tempest passed? Is it over, or will we have future problems?'" said Albrecht, an associate dean of BYU's Marriott School of Management. "You can't put it into a model -- two times 'A' plus 3 'B' equals fraud. We've never been able to do that. But we can say that if certain things are present, fraud is much more likely."
Executives most likely to commit fraud are those whose behavior is mainly motivated by self-interest to maximize personal wealth and who operate within low-control environments. They lead corporations with highly perceived pressures to succeed, and have ample opportunity to commit fraud because of lax controls or creative accounting, sometimes within a culture of fear where executives' actions aren't questioned.
On the other hand, executives most likely to act in the best interest of shareholders are those whose incentives are consistent with the satisfaction they derive from accomplishing challenging tasks and who operate in environments with strong controls. This high level of control keeps abuses of power in check. These executives would have a hard time committing fraud even if they wanted to but would rarely be inclined to do so.
"This is a feasible model that more companies should consider adopting," said Albrecht. "The more executives feel like stewards over their companies and the greater number of structural controls a company has in place, the less the likelihood of corporate fraud."