16 Jul After studying Symptoms of Fraud & Data-Driven Fraud Detection discuss the following: For the past year, you have been working as a secretary/processor for a local constructio
XYZ Homes
After studying Symptoms of Fraud & Data-Driven Fraud Detection discuss the following:
For the past year, you have been working as a secretary/processor for a local construction company, XYZ Homes, which specializes in the building of low-cost, limited-option homes. You left a comfortable, good-paying job to work for XYZ because it was family-owned and operated by longtime friends. Soon after you began working for XYZ, you noticed questionable behavior on the part of Mr. and Mrs. XYZ’s two sons, who are company salesmen. In fact, you are positive that they are falsifying documents to increase their commissions and to trick local banks into approving mortgages to customers who don’t meet credit standards.
You are trying to decide how to handle the situation when one of the sons approaches you and asks you to produce and sign a memo to a bank, falsely stating that a certain potential home buyer is creditworthy. You refuse to do so and, after much consideration, approach Mr. XYZ about the situation. To your surprise, he simply brushes off your comments as unimportant and laughingly states that “boys will be boys.”
- What would you do in this situation?
- Is the fact that you correctly refused to produce and sign a false memo enough, or are you obligated to report these crimes to the banks and proper authorities?
- Discuss the options, responsibilities, and implications you are facing.
Submission Instructions:
- Your initial post should be at least 200 words with at least 2 academic sources
Corporate Governance
Many compliance and corporate governance programs are formed as a result of a crisis. Organizations should start implementing effective corporate governance systems before a disaster emerges.
While establishing preventive measures might seem costly and burdensome, they are vital to the success, reputation, and longevity of a company.
Corporate Governance
The integrity and efficiency of financial markets depend on the reliability and transparency of financial reporting.
Corporate governance measures, such as an independent board of directors, an ethical corporate culture, and effective internal controls, play an important role in minimizing the principal-agent problem.
While it is impossible to completely eliminate this problem, incorporating a successful corporate governance structure can help mitigate the risk of fraud.
Cost of Fraud and Corruption
A typical organization loses 5 percent of its revenues to fraud each year.
Over 23 percent of the fraud cases caused losses exceeding $1 million.
Corporate Governance best practices essential in preventing and detecting fraud
•The impact of hotlines
•Anti-fraud controls at victim organizations
•Control weaknesses that contribute to fraud
•Fraud perpetrators’ relationship with the organization
Use of Hotlines
Among those organizations with some form of hotline in place, 51 percent of frauds were detected by tips.
Frauds that occurred in organizations without a hotline, 33 percent were detected by tips.
Control Weaknesses
Causes of a victim organization’s fraud occurrences include:
•Lack of internal controls (32 percent)
•Override of existing controls (19 percent)
•Lack of management review (20 percent)
•Poor tone at the top (8 percent)
What Is Corporate Governance?
Corporate governance refers to the procedures and processes by which an organization is operated, regulated, and controlled.
According to the Institute of Internal Auditors, corporate governance is “the combination of processes and structures implemented by the board in order to inform, direct, manage, and monitor the activities of the organization toward the achievement of its objectives.”
What Is Corporate Governance?
The underlying goal in a corporate governance system is to ensure that the decision makers in a company, such as its directors and management, are acting in the best interests of the company’s stakeholders.
Board directors are elected by shareholders to govern the company. The directors then appoint and oversee management to operate the company for the benefit of the shareholders.
Compliance and Ethics
Ensure that the company adheres to accepted ethical standards, best practices, and formal laws and regulations
Commitment to act with integrity, observe moral and ethical principles and professional conduct, and to accept accountability
Ethics are value based, not based on legal vs. illegal
Transparency
Corporate governance is about promoting fairness, honesty, and transparency.
Black’s Law Dictionary defines transparency as a “lack of guile in attempts to hide damaging information, especially in financial disclosures where organizations interact with the public.”
Transparency reassures stakeholders that they have a level playing field in which to invest and makes it more difficult for fraudsters to manipulate the financial statements.
Effective Corporate Governance
There is no “one size fits all” system of corporate governance.
Management must assess the organization’s structure and fraud risks to determine which principles of governance apply to their organization.
Regardless of the type and size, however, transparency, accountability, oversight, compliance, and protection of stakeholders apply to all organizations.
A corporate governance system can only be considered effective if it is successful in preventing and detecting fraud.
Corporate Structure
The checks-and-balances system of corporate governance ensures that no single party is capable of making all the business decisions without influence, input, or approval of other parties.
An organization’s corporate governance structure:
•Provides the lines of accountability and reporting
•Defines the relationships and expectations of the parties involved
•Sets the rules and practices that these parties must follow in carrying out their responsibilities.
Functions of Corporate Governance
Oversight
Compliance
Internal Audit
Legal
External Audit
Monitoring
Why Is Corporate Governance Important?
Good corporate governance enhances the reputation of an organization and makes it more attractive to investors, creditors, consumers, and donors.
Bad corporate governance can create an environment conducive to fraud and ultimately lead to the demise of an organization and significantly harm its stakeholders.
Perception
United Way
Perception is especially important to nonprofit organizations that rely on donations. Donors are apprehensive about contributing funds to a charity that is perceived to have poor governance.
This was evident in 2002 after the former CEO of the United Way of the National Capital Area was charged with defrauding the charity of nearly $500,000. Publicity of this scandal caused donations to decline dramatically, from $90 million in 2001 to $19 million in 2002.
Personal Liability
If a weak corporate governance framework allows fraud to occur, the CEO and CFO signing off on the financial statements can be held liable for damages incurred and sent to prison.
If any violations of Section 302 of SOX are found to be knowing and willful, guilty parties can face felony charges punishable by up to 20 years in prison and fines of up to $5 million.
Best Practices
While private companies and nonprofit organizations might not be required by law to follow these provisions, many elect to in case they want to go public in the future.
The structure and practices of the board of directors as required by SOX are considered best practices for private companies and nonprofit organizations, as well as for organizations outside the U.S.
Corporate Governance Reforms
1977 Foreign Corrupt Practices Act
1985 Committee of Sponsoring Organizations
1992 COSO IC Integrated Framework
2002 SOX
2002 SAS 99
2010 UK Bribery Act –toughest anti-corruption legislation in the world
Dodd Frank Act
Fraud Risk Management
Managing the risk of fraud is one of the primary reasons for establishing a corporate governance program.
It is much more cost effective to proactively address fraud risks than to suffer from preventable fraud and spend valuable resources to detect, investigate, prosecute, and clean up after it.
It is important for the board, management, and employees to have knowledge of their organization’s particular fraud risks, know how to identify instances of fraud, and constantly look for emerging risks due to the evolving nature of business.
Who is Responsible?
Successfully mitigating the risk of fraud is a goal of corporate governance. The following groups have a key role in dealing with fraud risk:
•The board of directors and audit committee
•Management
•Internal audit
•External audit
Board of Directors
The board of directors is the cornerstone of the corporate governance function.
Publicly traded companies are legally required to have a board, and many private companies and nonprofit organizations opt to have a similar governing structure.
It is widely accepted that an effective corporate governance system is ultimately the responsibility of the board of directors.
Board’s Responsibility
•Proactively participate in strategic decisions
•Ask management tough questions
•Oversee management’s actions
•Monitor management’s ethical conduct, financial reporting, and legal compliance
•Determine the company’s fraud risk profile
•Hire an ethical CEO
•Oversee the hiring process for other top executives
•Monitor management’s sustainable strategic, financial, and operational goals in achieving long-term shareholder value
•Set the agenda for board meetings
Board Independence
The independence of the board of directors is a critical component of corporate governance.
For many organizations, laws and regulations require a majority of board members to be independent.
To be considered independent, a director must not have any financial, social, or institutional connections with the company (other than his/her directorship) that would compromise his objectivity and loyalty to the company’s shareholders.
Board Independence
However, the more independent directors there are, the less they are likely to know about the company, its business, and its industry.
Conversely, the more directors know about the company’s business, organization, strategies, markets, competitors, and technologies, the less independent they become.
Yet people with thorough knowledge of the company are exactly what top management needs to contribute to its strategy, policy making, and enterprise risk assessment.
Need to achieve balance between executive and non-executive directors on a board.
One-Tier vs. Two-Tier Board
One-tier board – directors are responsible for both the performance of the organization and ensuring its interests are aligned with shareholders’. The board is expected to be involved in strategy formulation and policy making, while also supervising management performance and ensuring appropriate compliance with regulations.
The two-tier board structure avoids this problem by having the executive board responsible for performance and the supervisory board for conformance, with no common membership allowed between the two boards.
Board Selection
Shareholders receive a ballot with nominees selected by management. Most public companies in the United States use a plurality voting system, under which shareholders must choose to either vote “for” a director or to “withhold” their vote. If the election is uncontested, a director can win with just one “for” vote, and/or a majority of “withhold” votes.
Independent nomination of board members is critical to ensure there are no conflicts of interest, to prevent instances of collusion between board members and management, and to make certain that board members have the best interests of shareholders in mind.
Characteristics of a Good Board Member
Independent and willing to challenge management
Excellent analysts
Able to take a broad view of the organization and evaluate its objectives and strategies
Familiar with the challenges of a global organization
Risk and control experts
Versed in internal and external audit as well as financial reporting
CEO as Chairman of the Board
Investors tend to favor separation of the positions of CEO and chairman as a way to strengthen the board’s independence and reduce potential conflicts of interest. The advantages of separating these roles include:
•Better alignment with international corporate governance practices
•Improvement of CEO’s accountability
•Reduction in CEO’s potential conflicts of interest
•More effective board oversight
Director Compensation
•Director compensation should consist of both cash and stock
•All directors should own stock in the company
•Director pay should be comparable to peer-market groups
•Shareholders should approve director compensation
Board Committees
It is considered best practice for public companies to form at least the following three board committees:
•Audit committee
•Compensation committee
•Nominating committee
Audit Committee Responsibilities
•Appointing, compensating, and overseeing external auditors
•Reviewing financial reports
•Overseeing the effectiveness of both design and operation of the company’s internal control structure
•Reviewing management’s and auditors’ reports on internal controls over financial reporting
•Overseeing the company’s whistleblower policy and being available to receive tips from potential whistleblowers
•Overseeing the establishment and implementation of the ethical code of conduct
•Evaluating and communicating any possible instances of fraud to the company’s legal counsel
Compensation Committee
•Evaluation and compensation of directors and senior executives
•Providing shareholders with a Compensation Discussion & Analysis (CD&A) report, which contains:
–Details of executives’ service contracts
–Individual executives’ compensation
Nominating Committee Responsibilities
•Reviewing performance of current directors
•Assessing the need for new directors
•Having an objective nominating process for qualified candidates to the board
•Communicating any issues regarding board candidates with shareholders
Management
Corporate governance is designed to keep management in check and to ensure they do not have the opportunity or motivation to commit fraud. Management is responsible for making the day-to-day decisions that affect company performance and, ultimately, shareholder wealth. Corporate governance mechanisms should be established and maintained to properly align management’s interests with those of shareholders.
CEO
Sets the “tone at the top” of the company
Promotes ethical, professional conduct throughout the entire company
Is held accountable for the company’s long-term success
Fiduciary Duties – to act in the best interests of the company and its shareholders
Duty of loyalty – obligates executives not to:
•act adversely to the shareholders without consent
•Compete with the principal (shareholders)
•Wrongly communicate confidential information
Financial knowledge
Executive Compensation
With average CEO compensation in 2013 at $15.2 million, executive pay is often considered the most important corporate governance issue.
Executives receive a predetermined annual salary for their position according to their employment contract. They are also awarded a cash bonus for recognition of their performance above and beyond their salary base. The amount of the bonus is often tied to the company’s bottom line. And finally, executives are rewarded stock options for achieving sustainable shareholder value. This ensures that executive compensation is tied to shareholder wealth.
Incentivizing Ethical Behavior
A combination of stock options and cash is the recommended formula for executive compensation. That way, an executive has the short-term incentive to earn the cash and the long-term incentive to add value to the company so that his stock is worth more down the line. The key is to require executives who receive stock options or stock grants to hold the stock until retirement. If the compensation implements such policies, the interests of the executives are aligned with the interests of the shareholders.
Management Code of Conduct
•Avoiding conflicts of interest
•Protecting the confidentiality of proprietary information
•Cooperating with internal and external auditors, and respecting their independence to the company
•Promoting full disclosure in financial statements
•Certifying that financial statements are free of material misstatement due to fraud
Tone at the Top
“Tone at the top” refers to the ethical atmosphere that is created in the workplace by the organization’s leadership. Whatever tone management sets has a trickle-down effect on employees of the company. If the tone set by managers supports ethics and integrity, employees will be more inclined to uphold those same values. However, if upper management seems unconcerned with ethics and focuses solely on the bottom line, employees will be more prone to commit fraud because they feel that ethical conduct is not a priority within the organization.
Tone in the Middle
Employees are likely to model of behavior of standards set by their immediate supervisors.
Authoritarian tone does not lead to an open-door policy
When those in leadership positions display unethical behavior by committing fraud, their employees will follow suit, creating an entire culture of institutionalized fraud. When employees are pressured by management to meet unrealistic goals for the benefit of the company, they are essentially forcing employees to do whatever it takes to achieve those goals.
Internal Audit
The board’s most important source of independent, inside information
Internal auditors evaluate and improve the effectiveness of:
•Internal controls
•Risk management
•Corporate governance
Meet with the audit committee continuously throughout the year separately from management and the rest of the board
Should have an awareness of potential fraud risk
Act independent of management and ask tough questions
COSO Framework
COSO defines internal control as “a process, effected by an entity’s board of directors, management, and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in effectiveness and efficiency of operations, reliability of financial reporting, and compliance with applicable laws and regulations.” COSO’s framework designates three sets of business objectives:
•Efficiency and effectiveness of operations
•Reliability of financial reporting
•Compliance with laws and regulations
Components of COSO Framework
Control Environment
Risk Assessment
Control Activities
Information and Communication
Monitoring
Professional Skepticism
SAS no. 99 (codified in AU §240) reminds auditors that they need to overcome some natural tendencies—such as overreliance on client representations—and biases and approach the audit with a skeptical attitude and questioning mind. The auditor must set aside past relationships and not assume that all clients are honest.
AU §240 also requires that external auditors provide reasonable assurance that the financial statements are free of material misstatement, whether caused by error or fraud, in order to render an unqualified opinion on the financial statements.
Audit Committee Oversight
Any disclosure of fraud to the audit committee by the auditors or management should generate an immediate investigation by the audit committee (or their legal counsel).
Whistleblower
A whistleblower is a person who alerts someone in a position of authority to an instance of wrongdoing, such as breaking the law, fraud, or corruption.
Whistleblowers are invaluable to the detection of fraud.
Many whistleblowers elect to use hotlines
Whistleblower Policies
Every organization should have a formal whistleblower policy in place. The policy must be well publicized and include:
•The various reporting mechanisms available (phone, email, etc.)
•Whether the reporting system is anonymous and confidential
•How tips will be handled
•What types of tips should be reported (financial statement fraud, unlawful activity, violations of company policy)
•Whistleblower protection against retaliation
•Repercussions for false tips made in bad faith
Fraud Prevention Culture
An organization’s culture is arguably just as important as its compliance efforts. Fraud prevention has always been a requirement of sound business; laws and regulations are simply in place in an effort to address fraud and promote transparency. However, compliance alone is not enough to prevent fraud.
Anti-Fraud Policy
An enforceable code of ethics and an official anti-fraud policy are essential components of any organization’s corporate governance system. An official code of ethics can eliminate confusion regarding a conflict of interest or questionable act. Furthermore, it emphasizes the company’s commitment to integrity. A code of ethics is a requirement under SOX.
While codes of business ethics and conduct are intended to govern behavior, they cannot substitute for moral principles, culture, and character.
Anti-Fraud Policy
Creating a culture of compliance requires more than simply following laws and regulations. The determined fraudster can often find a way to override controls or work in collusion to perpetrate fraud. Therefore, a culture of compliance requires adherence to core values. Integrity and honesty are core values for all employees. Management that intends to prevent fraud successfully must constantly reinforce these values. Effective fraud prevention requires a culture of integrity demonstrated by both the board and management, along with a zero-tolerance policy for fraud.
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