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In recessionary times, the incentives to cheat increase as executives face more pressure to meet revenue and earnings targets
With the news out of India that outsourcer Satyam Computer Services' accounting statements were a work of fiction worthy of John Grisham, 2009 has its first major case of corporate accounting fraud. But if experts in white-collar crime are right, as long as the recession is under way, it won't be the last.
During a Web conference conducted by Deloitte Financial Advisory Services' Anti-Fraud Consulting Services, nearly two-thirds of 1,500 executives who chose to respond to a poll said they expected more frauds to be uncovered as the economic downturn continues. While that result could be skewed because of who was polled—they all had an interest in fraud going in—history backs them up.
Data from the National White Collar Crime Center show a spike in arrests for fraud and embezzlement during the two most recent recessions. Following the savings and loan crisis and the downturn in 1990, white-collar fraud arrests jumped 52% over the next two years; following the Internet bust in 2000, arrests jumped 25% in the following two years. "White-collar crime clearly upticks when there's a downturn in the economy," says Michael B. Himmel, a defense attorney specializing in white-collar crime at Lowenstein Sandler and a former federal prosecutor.
Inside the "Fraud Triangle"
In better times, Satyam (SAY) might have been able to complete the buyout of two Indian construction companies, which would have plugged the holes in its balance sheet. Instead, investors revolted, leading to co-founder Ramalinga Raju's revelation that $1 billion was in fact a mirage. If the Satyam case sounds familiar, it should. Following the collapse of the Internet bubble, massive accounting frauds were found at Enron, WorldCom, and Tyco, driven in part by the need to maintain a sky-high stock price. "When markets are going up it's easy to hide all sorts of shenanigans," says Robert Wright, a financial historian at New York University. "When markets start to founder, it's harder to keep up the charade."
But it's not only old frauds that investors need to worry about. As the recession lumbers on, executives will face more pressure to meet revenue and earnings targets and demonstrate their ability to manage through a downturn. And with some economists predicting a double-digit unemployment rate and a slew of corporate defaults, they may also be motivated by the desire to stay in business and keep their jobs. "The reason there's an increased risk of fraud in a down economy is the 'fraud triangle.' You have the pressure, opportunity, and rationalization," says Donna Epps, a partner with Deloitte Financial Advisory Services' anti-fraud practice.
Unfortunately for investors, fraud is never easy to spot. (A quick glance at Satyam's financial statements didn't reveal anything too fishy, other than growth being a little too consistent, even to those who know what to look for.) But new tools may aid in uncovering fraud. Forensic accountants are already using technology to probe historical data to find anomalies in the numbers and data mining e-mail for terms that may indicate some nefarious plot is afoot. Future improvements in the power of software will help accountants spot fraud even as it is occurring. "The ability to probe massive amounts of data quickly will be a significant factor in uncovering fraud," says forensic accountant Mary O'Connor of RGL Forensics in Chicago.
Coordinated Oversight Needed
Fixing the regulatory system will be another deterrent to fraud. A U.S. Government Accountability Office report issued Jan. 8 found that the system as currently constructed is too fragmented to do its job. The GAO recommends creating a comprehensive system with clearly defined goals. It doesn't help that some regulators may have aided companies in their attempts to circumvent the rules: An official with the Office of Thrift Supervision allegedly helped failed California thrift IndyMac backdate a cash infusion to avoid attracting attention from the Federal Deposit Insurance Corp.
For those hoping to rein in financial fraud, President-elect Barack Obama's economic speech on Jan. 8—in which he called for more regulatory scrutiny—was a good start. Says O'Connor: "We need to throw out antiquated systems and get regulation that will restore confidence in the economy."