Answer:

Fraud - An introduction

Fraud has been defined by the Institute of Internal Auditors (IIA) as " any illegal act characterized by deceit, concealment, or violation of trust. These acts are not dependent on any threat of violence or use of force. Frauds are perpetrated by parties and organizations to

i. obtain money, property or services;

ii. to avoid payment or loss of services; or

iii. to secure personal or business advantage".

Types of Fraud

Fraud is perpetrated by:

i) Internal Fraud by employees of an organization;

ii) External Fraud by Suppliers and Customers of the organization;

iii) Fraud against individuals.

Reasons to commit fraud?

Mr. Donald R. Cressey identified three reasons for people to commit or perpetrate fraud. They are :

I) Opportunity;

2) Pressure; and

3) Rationalization or justification.

Opportunity

Opportunity is present in the form of weak internal controls.

Pressure

Pressure creates an incentive or motive to perpetraate fraud. Pressure could manifest in the form of Financial Targets that organization release every quarter to the Exchanges, or pressure created by gambling debts, or credit debts debts etc.

Rationalization or Justification

Rationalization is nothing but an attitude or an ability to rationalize the perpetration of fraud.

The three reasons are depicted as three corners of the Fraud Triangle. However, the Fraud Traingle has now given way to the Fraud Pentagon. Two more reasons have been added to the existing three reasons to commit fraud. They are:

1. Arrogance: Senior people or people with "big egos" who think the laws or organization rules do not apply to them or people who are of the opinion that internal control overrides are acceptable as far as they are concerned.

2. Competence : "Competence gives the perpetrator the opportunity to transform desire into reality". Competence is derived from a senior position, exceptional intelligence and competence at work, personal confidence, coercive skills, and an ability to remain stress-free.

These five reasons together provoke fraud perpetrators to commit fraud.

Major Frauds

There have been several frauds that have been discovered in the last two decades. Some major frauds are:

1. Enron;

2. Worldcom;

3. Adelhphia;

4. Tyco;

5. Satyam;

6. Parmalat.

In the following paragraphs, we will be discussing the Worldcom fraud that resulted in a loss of $ 7.1 Billion.

The Worldcom fraud

Worldcom was America's second largest telecom company. Second largest in terms of long-distance and largest handler of internet data. Worldcom filing listed more than $ 107 Billion in assets, more than even Enron. Worldcom grew by raid acquisitions funded by debt totalling $ 41 Billion.

Availability of cheap and abundant financing enabled companies like Worldcom to build transcontinental and transoceanic fibre optic networks in the 1990's. The surplus additional capacities thus created resulted in supply driving prices down for companies like Worldcom. Worldcom's services includes basis phone services and transmission of internet data for large companies.

What did Worldcom do?

The Chief Financial Officer of Worldcom Mr. Scott D Sullivan was guilty of :

a. Devising a strategy that wrongly accounted for $ 3.85 Billion of expenses improperly reported in the financial statements as " Capital investments". It is well known that operating expenses MUST Be deducted from revenue immediately, whereas the cost of capital expenses could be "spread' over a period of time. Improperly spreading normal expenses, that should have been deducted from revenues inflated profits.

b. Improperly recording $ 3.3 Billion of profits in the company's books from 1999 to the first quarter of 2002. This involved the "manipulation of reserves". Companies normally set aside reserves to cover losses such adverse ruling in law suits, uncollected payments from customers etc.

Creating or setting aside reserves is normal business practice, as these represent funds parked for the rainy day. But a company can also tap into reserves to meet the Wall Street's expectations on financial performance. It is surmised that the Chief Financial Officer deliberately padded/ inflated the reserves so that he and his team could dip into them when profits from business operations went into a nose dive. By dipping into the reserves, he could help the company post financial results that met the Wall Street's expectations.

How could this fraud have been prevented?

It is very obvious that this fraud was committed by the Chief Executive Officer (CEO), Chief Financial Officer (CFO and their team to meet unrealizable "financial targets" to the investor on wall Street despite being aware of the falling prices of telecom services. The CEO, Mr. Bernie Ebbers was keen to drive business growth through acquisitions through manipulating the price of the Worldcom stock. The increase in share price could be used to fund the acquisitions. There was pressure on the CEOO to therefore justify the acquisitions through over-stated revenues and under-stated costs.

The fraud was committed on account of :

a. Pressure to meet the expectations of the Wall Street crowd despite a meltdown in the telecom industry;

b. Suppression and witholding of operational and financial data from their internal auditors and external auditors. They leveraged their seniority and possibly used coercion to keep data away from financial audit and scrutiny over a ten year period.

c. An opportunity to extraact bigger bonuses based on their supposedly meeting profit projections. There was a desire by the CEO to protect his personal financial status.

The fact that the internal auditors discovered the fraud only in 2002 clearly shows that both sets of auditors failed in their duties to the management and the shareholders.

Improvement in quality of Audit could have prevented the scandal

It was obvious that the auditors did not do a preliminary survey of the industry and the companies results over the ten year period. It is also obvious that that the auditors failed to trace the unjustifiable inflation of reserves.

An Independent Board of Directors could have prevented the fraud

An active and independent Board of Directors could have stepped in earlier to conduct investigations. They did not do so, and it is apparent in hindsight that they might have been in collusion with the CEO in driving up profits.

A Signed Code of Ethical Behavior among the Leadership Team, and percolated downwards, could have prevented the fraud

The Tone-At -The -Top could have been based on "candour" and ethical conduct. There was conflict of interest and deceit in the behavior of the CEO, CFO and their team;

Documented Policies and Procedures, including a Whistleblower Policy

A formalized and well documented set of policies and procedures could have been implemented earlier. Including a employee grievance Cell and Whistleblower policy could perhaps have opened communication channels between the Board and the employees earlier.

Involvement of Lawyers and Experts

The Board could have included an member who is an industry expert alongwith another who is an expert in law. Seeking the advise of such experts and lawyers by an independent Board could have helped to nip the crisis in the bud.