Crisis of Confidence: An interview with fraud expert W. Steve Albrecht

Several reports indicate that fraud—particularly corporate fraud—has increased dramatically over the past decade. Reports not only show an increase in the number but also in the size of corporate frauds. Has fraud really increased, or are we just better at detecting it than we used to be?

Fraud is increasing. There have been two monumental studies of financial statement frauds. One was done in the early 1990s on frauds detected between 1977 and 1987. There were about 300. The other study looked at the next ten years and found about 325 frauds. Since 1997, already more than 300 frauds have been detected. So, in the last five years there have been as many financial statement frauds as in the previous ten years. 

Whether we are better at detecting it than we used to be has a lot to do with the fact that frauds are easier to conceal in a strong economy. Many of the recently detected frauds were going on in the 1990s but were masked by the healthy economy. 

Another change that has taken place is the increase in the size of frauds. The largest bankruptcy in history, up until the last couple of years, was around $25 billion. Now, Enron is at $63 billion and WorldCom $102 billion. Four of the largest bankruptcies in history have involved financial statement or management fraud.

To what do you attribute the dramatic increase in fraud, particularly over the past decade?

As I mentioned, a lot of these frauds have been going on before but weren’t detected until the economic slowdown. Beyond that, it’s corporate greed. Look at WorldCom’s and Enron’s executives. They were making millions a year in salary but stood to make hundreds of millions in stock options. The stock price doesn’t go up unless earnings are consistently increasing. Wall Street and investment bankers project what a company’s earnings should be, and if companies don’t meet those projections, they’re heavily punished.

For example, Enron reported twenty straight quarters of increasing earnings when, in fact, their real earnings were significantly less than that and in many cases losses. Because Wall Street penalizes firms that don’t meet earnings expectations, there is enormous pressure to increase earnings, which often leads to manipulating or “cooking” the books to meet forecasts.

Is fraud more prevalent in the United States than in other developed countries?

Compared to other developed countries, fraud is more prevalent in the United States. There’s a German organization, Transparency International, that rates corporate corruption in various countries. The corruption index is based on about thirty different surveys. The United States for the last few years has been ranked sixteen or seventeen out of about one hundred in the world. Canada ranks around seven or eight. The most honest countries tend to be in Scandinavia—Denmark, Sweden, and Norway. Less-developed countries tend to be closer to the bottom. 

Do you believe the United States is experiencing a crisis of conscience?

There’s a crisis of confidence for sure. Whether there’s a crisis of conscience, I’m not sure. I can tell you that a lot of action has been taken recently. We have the new Sarbanes-Oxley Act, also called the Corporate Responsibility Act, that has many elements such as creating a new oversight board for the accounting profession and making executives sign off on the accuracy of their financial statements. 

There are many steps being put in place to minimize future fraud activities. Having said that, we will always see corruption, because there are a million different ways to commit fraud and a lot of greedy people willing to do it.

Is the crisis of confidence justified?

Unfortunately, bad news gets all the press. Bad press is dominating the news and shadowing everything we do. By and large, we’re still a great system with mostly honest companies. Sure we’re in a bit of a recession right now, but most companies are going to survive and become stronger. 

I think a lot of people have overreacted. We hear about WorldCom, Enron, Tyco, or Homestore frauds, and all of a sudden it seems like it’s everywhere. But it’s not. What we don’t think about is how many companies are out there. It’s like flying. People hear about a deadly airplane crash and are afraid to fly. They may not think about the fact that there are thousands of flights a day, and it’s still the safest way to travel.

You’ve written about the fraud triangle—the role of perceived pressure, perceived opportunity, and rationalization in committing fraud. How do these factors play out when fraud is actually committed? 

The fraud triangle can explain any fraud there is. If it’s fraud against an organization, the pressure might be, “I’ve got debts I can’t pay.” The rationalization is, “There are poor controls in the organization, and I’m going to pay it back.” 

If it’s financial statement fraud for example, the pressure might be, “We’ve got to meet Wall Street’s earnings forecast.” The opportunity would be the plan, “We’ll bury these fictitious transactions in subsidiaries that the auditors might not get to.” The rationalization is, “As soon as the economy improves, we’ll merge with somebody and create a merger reserve where we can wipe this out.” People rationalize that as soon as the economy improves they’ll stop committing fraud. 
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Some in the United States believe the American system of accounting—most notably the rules-based system administered by the Financial Accounting Standards Board—is to blame for the discrepancies and deceit perpetrated on investors. Critics of the American system believe that moving to a principle-based system like that used in Europe would reduce the penchant many have for regulatory loopholes.

How seriously is the U.S. accounting profession looking at moving to more principles-based International Accounting Standards (IAS)?

The United States has not been heavily influenced by the IAS. International standards are different and more principles-based. I doubt we’ll be adopting them in the foreseeable future because most people believe U.S. standards are higher. 

This principles/rules-based controversy doesn’t have an easy solution. Some people argue that if we have more principles-based standards it’s just easier to manipulate because there are no hard rules. The problem with rule-based standards is you can’t have a rule for everything. In a rule-based system, the auditor can’t say to the client, “You shouldn’t do it because there’s a rule against it.” But if it’s principles-based, the auditor can say, “You shouldn’t do it because it’s not in the spirit of the rule.”

Overall, if auditors are willing to stand up to their clients, I think principles-based standards would be better. It would be harder to rationalize if you had principles-based standards that everybody understood and complied with.
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What would it take to move in that direction?

It would take a lot of people changing their belief structure. We’ve gone down this rule-based road a long time. Many people who’ve invested a lot would have to change. It’s not in the FASB’s best interest to have general principles-based standards. However, I think it’s in the best interest of financial reports and the country as a whole. A lot of people don’t agree with me on this point. They believe principles-based standards would give people a license to cheat more. I don’t believe that. 

Do you feel government regulations, particularly the new Sarbanes-Oxley Act, do much to reduce perceived pressures, opportunities, and rationalization?

The Sarbanes-Oxley Act is an effort to put some infrastructure in place to make companies act responsibly. The act created an oversight board, requires auditor rotations, and requires work papers to be retained longer. It places more burdens on corporate executives. For example, you can no longer leave a CPA firm and become a company executive right away. Certain executives in corporations have to sign off on financial statements. And, companies must have outside directors with financial experience on their boards of directors and audit committees. 

I don’t think we’ve done anything to reduce pressures. We still have Wall Street making earnings predictions and companies giving tremendous amounts of stock options. In terms of opportunity, hopefully by having more diligent auditors, opportunities won’t be as great. As for rationalization, if top management has to sign off on the financial statements and take responsibility for their accuracy, they can’t rationalize fraud as easily as before.

Have advances in technology helped eliminate or encourage fraud?

Yes and yes. Advances in technology have made fraud easier to commit and easier to detect. We can now use deductive logic and technology together to detect fraud. I’ve done it with my son, Professor Conan Albrecht, as the programmer. 

First, we identify the kinds of frauds that could occur. Then, we identify the symptoms those frauds would generate and catalog them. Next, we use the company’s accounting systems and technology to search for these symptoms. When we find things that look like fraud, we build models. 

On the other hand, advances in technology have made fraud easier to commit as well. For example, there’s a lot of online auction, credit card, and identity fraud that was never possible before. 

What is the Marriott School doing to prepare students to deal with fraud issues? 

For starters, we have excellent professors who are marvelous examples. They’re bringing the gospel and good values into the classroom. They are staying up-to-date and using corporate examples to teach lessons of integrity and to teach students how frauds happen. We also bring in business executives as lecturers  and role models. 

Aside from the Sarbanes-Oxley Act, what do you think needs to be done to restore confidence?

Unfortunately, the solutions are difficult. Some people are dishonest. Researchers who have studied honesty, integrity, and moral development say there are two things to do if you want somebody to be honest. Number one, you’ve got to model the behavior you want. In the corporate world we call that “tone of the top.” In a family, we call it setting a good example. Number two, you’ve got to label behaviors as acceptable or unacceptable. In the corporate world we call that a code of conduct. In a family, we call it teaching and training. 

It’s very clear from research that when the model and label or the example and teaching are not consistent, you get a behavior you don’t want. It’s like me saying to my children, “Don’t break the speed limit.” Then they get in the car with me, and I drive eighty miles an hour with a radar detector. My model and my label or my teaching and my example are not consistent. The Savior was a great example, a perfect example. His labeling was parables, and His model was His example. 

In today’s society productive modeling and labeling is diminishing. With information so accessible, people are exposed to a great deal of poor behavior that is modeled very vividly. Young people are seeing more bad models, and some of these models are our leaders: executives, athletes, senators, and judges. 

Not only are the youth being exposed to poor examples, but they aren’t receiving the teaching to help them determine what behaviors are acceptable and unacceptable. I’ve heard that the average vocabulary of a kindergarten child today is about 1,000 words. When the baby-boomers started kindergarten the average was about 4,000 words. Children have decreasing vocabularies because they’re not being talked to. The average family spends ten hours less time together per week today than in 1980. Homes are no longer places where parents teach and train children, they’ve become places where you pass each other in the hallway and say hi. 

With little or no positive modeling, teaching, or training, children are growing up and entering the corporate world without a well-defined code of conduct. They don’t know what’s right and wrong. When the company CEO tells them to do this, or the chief financial officer tells them to do that, they rationalize and go along. They say, “I’ve got this good job. I’ve got to keep it.” 

The problem is there are a lot of people to blame. There have been honesty studies in the United States for many years. We know that the percentage of dishonest Americans is increasing. It’s a very difficult trend to reverse. 

Is it possible to reverse that trend?

If we’re going to reverse it, we have to start at home. Then, educational institutions have to pay attention. Business schools aren’t teaching ethics as much as they could or should. Few are teaching anything about fraud. Most of the people who participate in frauds and most of the auditors wouldn’t know fraud if it hit them right between the eyes because they haven’t been taught. I believe teaching about fraud will help reverse the trend. 

In addition, we have a fraud class at BYU. Now, a number of other schools are adding fraud classes. We also have several other classes that present students with ethical dilemmas to help them define who they are. 

Looking at situations like WorldCom and Enron, do you think it was really their intent to manipulate their earnings all along?

The common element of fraud is intent. Without intent, it’s an error. Sometimes the intent starts fairly innocently and grows gradually. That first amount of fraud committed usually offsets the second period. The next period’s fraud always has to be bigger. People who commit fraud usually don’t realize that unless they can reverse it very quickly it’s going to get really big.

For example, one of the easiest ways to commit fraud is to overstate inventory. If you overstate inventory, then your gross margin and net income are higher. Inventory at the end of one period becomes the beginning inventory of the next period, which has the opposite effect. So now to commit a fraud you’ve got to compensate for that as well as double it the next period. In most cases, frauds start small and then grow geometrically. In WorldCom’s and Enron’s cases, they first used aggressive accounting methods then managed earnings and finally committed fraud.

Do you believe that fraud at this magnitude also begets other fraud? People think, “Well, nobody’s being honest, so why should I?”

This happens a lot. When top executives are dishonest other people in the organization see it and justify their own dishonesty. An insurance fraud a number of years ago involved employees creating fictitious people and fictitious policies and then selling those policies to reinsurance companies. One of the employees in the company saw what was going on and said, “We’re creating all these fictitious employees, I might as well get in on it.” It didn’t make sense to have them all live forever, so he had a few of them die and collected the death proceeds. I’m an expert witness in a fraud case right now where there are more than twenty individuals involved in perpetrating the fraud.

Not only have CEOs been taken to task for duping investors, but their accountants and auditors have also come under intense fire.

Should corporate accountants and independent auditors be held to the same level of accountability as CEOs?

Despite what many people think, accountants and auditors are rarely involved in fraud. There are a number of lawsuits against auditors that I consider frivolous. An auditor will never be able to detect every fraud. They’d have to audit 100 percent of all transactions, be an interview expert, and be able to tell when somebody is lying. Just because somebody doesn’t catch a fraud doesn’t mean it is a failed audit. 

Having said that, I believe there are cases when auditors aren’t as diligent as they should be. I’ve been engaged as an expert witness in cases to defend CPA firms and started preparing only to realize the auditors didn’t do a good job. When that happens, I resign from the engagement. 

Where is the accounting profession headed?

The accounting profession has been hit pretty hard and gotten a lot of bad press lately. We’re down now to the final four firms, if you will. You may have recently read that one of the big four has a $2 billion lawsuit against it by the government. For many years, CPAs were at the top in terms of integrity, objectivity, and respect. Now, many people argue that we’re down there with used-car salespeople, lawyers, and members of congress. We lost a lot in a short time in terms of our reputation as accountants. It’s going to take a long time to get that back. The irony is, however, that CPAs should now matter more than ever to corporate executives. They place great confidence in their auditors before signing off on financial statements.

How long do you think it will be before the markets regain consumer confidence? 

The problem with the markets right now and consumer confidence is it’s not just the frauds that are holding the market down. In fact, they might be a fairly small part of it. It’s a combination of the unemployment rate, economic downturn, and the indices we monitor all the time. When people lose money, they tend to have less confidence in the system. 

One of these days the economy is going to turn around, and as a result consumer confidence will rise. If you look at the market historically, we have never had a period longer than twenty-two months when the market’s been down. When it has recovered, it’s exceeded its previous high. We’ll still have frauds, and the strong market will hide many of them. It’s cyclical.

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Article written by Joseph D. Ogden
Illustrated by Steven Noble