LA FORMULACIÓN DEL PRODUCTO TURÍSTICO

Chapter 3 – Fraud Prevention: Pressures and Rationalizations

Learning Objectives

After completing this section of the course, you should be able to: 1. Identify the pressures and rationalizations that can lead to fraud.

2. Design programs to relieve workplace pressures and help prevent the occurrence of fraud. Employee Financial Pressures

The list of pressures employees face is long. We will discuss some of the most common here and illustrate them with real cases of fraud. (A more complete list of pressures and risk factors can be found in SAS No. 99, Consideration of Fraud in a Financial Statement Audit.)

Bad Investments or Heavy Financial Losses

One financial pressure is bad investments or heavy financial losses. An illustration of how financial losses can create enormous pressures is the following case of an owner of a grain elevator in Stockport, Iowa.

Example: Raymond Keller was the owner of a local grain storage company. He built a lavish house overlooking the Des Moines River, complete with a swimming pool, sauna, and a three-car garage. However, for reasons no one really knows, his financial situation declined. Some say he lost money speculating on the commodities markets. Others say it was a grain embargo that virtually halted the buying and selling of grain. Keller had a severe cash shortage and went deeply in debt. He asked some farmers to wait for their money and gave others bad checks. Finally, the seven banks to which he owed over $3 million called their loans. He began the unauthorized sale of the stored grain and used the proceeds to cover his losses. One day a state auditor appeared unexpectedly. Rather than face the consequences, Keller took his own life. Excessive Lifestyle or Living Beyond One’s Means

Many fraud perpetrators seem to be attracted to what may be referred to as a life of conspicuous consumption. They are extroverted, fun-loving, social individuals who enjoy the feelings that come from influence, social status, and from spending large sums of money. They are often imaginative and are more than ready and willing to take large risks to get what they want. Example: Tony De Angelis, who perpetrated the Salad Oil Swindle, was known for his

chauffeur-driven Cadillac, his large and risky deals, his influential associates, and his free-spending habits. He often gave cash away to his many admirers.

Example: One man, after founding a student marketing company, changed his lifestyle dramatically and developed very expensive tastes. He bought a Lear jet and a very expensive home, threw extravagant parties, and tried to portray himself as an elitist. Others commit fraud to cover up the free-spending ways of a family member.

Example: One woman began embezzling funds when her husband went on a spending spree after a marital squabble. She felt compelled to cover the checks he wrote.

Chapter 3: Fraud Prevention: Pressures and Rationalizations

Inadequate Compensation

Another financial pressure is “inadequate” compensation. The following are some examples of this type of pressure.

• Some employers expect an employee to maintain a certain lifestyle to foster a certain image or engage in certain activities to bring in new business, yet these same employers do not provide an adequate income or expense account to enable the employee to do so. In such cases, the employee often faces the choice of not meeting company expectations of finding other funds to achieve the objective.

Example: A partner in a national CPA firm felt he was expected to frequently wine and dine clients and potential clients. As a result he seriously overextended himself

financially. When an important client offered him a bribe to hide fraudulent financial reporting, he agreed to look the other way. For a $150,000 payment, he concealed a $300 million fraud. As a result, a large savings and loan failed, as well as several other companies.

• Employees do not receive sufficient wages to meet their family’s perceived needs. Example: Tom was the head shipper at a large manufacturer of gas appliances and related

equipment. He had to support his wife and nine children on a small salary. The pressures of family expenses finally became so great that he began stealing small appliances and fixtures from the warehouse. He sold the items and bought all kinds of things his family needed at home.

• Some people do not feel they are adequately rewarded for their efforts and labors. Example: Two brothers who ran a software store in Pakistan wrote a computer virus and

inserted it in the software they sold. After the virus damaged the user’s system, it left a message directing the user to call the brothers for costly corrections. It infected over 100,000 computers before it was eradicated. When asked about their motives, the brothers said they were upset that computer users were illegally copying the store’s legitimate software, so they caused the virus to be activated when an illegal copy of the software was made.

High Personal Debt

A fourth financial pressure is high personal debt. This may result from: • The loss of a business or home;

• Divorce;

• High medical bills;

• Extended periods of unemployment or underemployment; • Impending personal bankruptcy; or

• Bad business decisions or reversals in the economy.

Chapter 3: Fraud Prevention: Pressures and Rationalizations

their home or business or go bankrupt. The perpetrators may not consciously make this decision, but their actions reveal what is most important to them.

Example: The controller of a small bank embezzled $158,000. Prior to working at the bank, he had worked for one of the then-Big Six firms and had earned a CPA certification. He was the son of a judge, and had never stolen anything before. When interviewed, he indicated that he had committed the fraud for two reasons: (i) he had gotten a divorce and had two households to support; and (ii) his outside business was losing money and draining his personal funds.

Example: Alex was the 47-year-old treasurer of a credit union. His monthly payments on his home, cars, five different credit cards, two side investments, and college for two children exceeded his take-home pay. He felt the only way to make ends meet was to commit a fraud. He misappropriated assets to help pay his crushing debts and

defrauded the credit union of $160,000 over a seven-year period. He was very well respected, so his actions came as a great surprise to all who knew him.

Greed

Some people have an overwhelming desire for personal gain. Others have a compelling desire to “get something for nothing.” Put another way, some people are so greedy they will commit a fraud to get what they want.

Example: As a youngster, Gene found that baseball cards had value, so he took quarters from his mother’s purse to buy chewing gum, hoping for cards other boys would want to buy or trade. The prospect of getting something for nothing intrigued him, and he began pitching pennies, organizing sports pools, and gambling. He talked neighbors into letting him turn in magazine entry sweepstakes, agreeing to split the winnings. He did little in high school, conning many teachers into giving him A’s, and

accepting F’s from the others. After high school, he moved from job to job, looking for a way to “score big” and set himself up for life. Soon after his second child was born, a racetrack insider alerted him to a racehorse that was a “sure thing.” Gene bet all of his savings and the proceeds of a second home mortgage on the horse. It came in fifth. Gene called his wife from the racetrack, told her how he had defrauded her, and disappeared. His wife lost her house and car. Her parents refused to help her (they disapproved of her marriage). She had to take a minimum-wage job and felt bitter, betrayed, and abused.

Desire to avoid paying taxes

The desire to avoid paying taxes to the government can lead people to do amazing things, including fraud.

Example: In 1985, Phillip Capella won $2.7 million in the lottery, and began receiving annual payments of $135,000. In 1989, he filed a federal income tax return claiming $65,000 in gambling losses and seeking a $26,000 refund. The IRS audited him, and his accountant showed up at the audit with 200,000 losing lottery tickets. However, the tickets did not belong to

Chapter 3: Fraud Prevention: Pressures and Rationalizations

accountant were charged with conspiracy and each faced a possible eight-year jail term and fines of $500,000.

Pride and Ambition

Pride and ambition also lead some people to commit fraud. Perpetrators motivated by pride and ambition often feel they are above the rules because they are better than other people and more deserving. They are often unhappy with ordinary jobs and income. The outward signs of success can become an obsession that may be manifested in their mode of travel, dress, and lifestyle. Extending themselves beyond their means is not unusual. This attitude causes the offenders to decide to get what they want by whatever means necessary. Pride blinds them to possible consequences.

A Need For Power or Control

For some, a need for power or control may surpass their considerations of right or wrong. If other avenues to power, position, or prestige are blocked, money, which symbolizes power, may preoccupy the person who is determined to “be somebody.”

Inability to Tolerate Delay or Frustration

Some perpetrators are unable to tolerate delay or frustration. In such personalities, failure in legitimate efforts simply stimulates a more earnest search for a shortcut to success. A course that is slow, plodding, and lacking a guarantee, such as beginning at the bottom and working one’s way up, is unthinkable. The temptation of easy gain or instant success is more than these people can resist. They want to resolve their financial problems or “hit the big time” immediately, in any way they can, with minimal effort and cost, no matter what the impact on the business or other people.

Insatiable Intellectual Challenge

A common finding, especially with computer criminals, is that they are often motivated by intellectual challenges. Many computer technicians are insatiably curious and thrive on the challenge of figuring out how things work. A technician could easily find himself thinking, “I will figure out how they made this system secure, break that security, and prove my superior technical capabilities.” For many technicians, this challenge may well be a greater enticement than the possibility of financial gain. Once tempted by this kind of gamesmanship, computer criminals can become so involved they lose sight of the moral implications of their actions.

Management Financial Pressures

Pressures can also motivate an individual to commit fraud on behalf of an organization instead of against it.

Economic Cycles, Inflation, and Recession

The economic cycle and the resulting effects of inflation and recession are a major management fraud pressure. In recessionary times, executives who fear layoffs or downsizing may resort to financial gimmicks to boost the bottom line and protect their own jobs as well as their workers’ jobs.

Chapter 3: Fraud Prevention: Pressures and Rationalizations

Example: In a recent survey, 98 percent of the CEOs at the top 1,000 Canadian companies stated they felt that economic pressures were the main reason for Canadian companies reporting fraud-related losses of $39 million.

Impending Business Failures

Another corporate pressure is an impending business failure. Though business failures

significantly increase in recessionary times, there is a significant relationship between impending business failures and fraud even in the best of times.

When faced with the choice of either losing their businesses and everything they have worked for over the years or “fudging” (in their eyes) the numbers a little bit in order to keep the business going, many owners choose the latter course. In the latest recession, business failures increased 50 percent. The dollar liabilities associated with business failures skyrocketed from $55 billion to almost $110 billion.

Urgent Need For Earnings

Companies that face pressures for a certain level of earnings (to meet debt requirements, go public, etc.) are sometimes motivated to fabricate those earnings or turn to sleight-of-hand tactics if they are not able to generate them honestly.

Example: In 1989, Bonneville Pacific, facing a net loss of $2.5 million, badly needed a deal to meet investor earnings expectations and to avoid a poor showing during discussions with underwriters for a debt or equity offering. To meet those earnings expectations, it recognized a $13.2 million gain on a complex, two-step purchase and sale of assets. The bankruptcy trustee claimed the transaction was a sham to artificially boost the value of assets assigned to Bonneville. He said it involved insider dealing, inflated earnings, and secret funneling of cash through an offshore shell. An auditor with Bonneville’s then-Big Six CPA firm wrote in a memo that the transaction presented an unusual audit risk to the CPA firm. The memo also criticized Bonneville officials for accepting such unusual risk, for offering overly optimistic public projections of earnings, for using aggressive accounting policies, and for trying to promote the company and increase stock prices. Notwithstanding the memo, the CPA firm gave Bonneville a clean opinion.

Unfavorable Economic Conditions

Companies facing unfavorable economic conditions are sometimes motivated to fabricate earnings or otherwise falsify information. The declining financial condition of entities in an industry is evidenced by things such as declining stock prices, delisting or suspension of stock, credit downgrades by rating agencies, and frequent or increasing numbers of business failures. Example: The Equity Funding Fraud was one of the largest computer-assisted frauds in history.

In 1969, Equity Funding’s stock sold for over $80, but because of difficult times in the insurance industry the stock fell to $12 by late 1970. Company managers with vast holdings of the stock were intent on boosting its price. They felt that the only way to do that was through higher and higher earnings. Unfortunately, new sales were down for the industry and existing policyholders were not renewing their

Chapter 3: Fraud Prevention: Pressures and Rationalizations

insurance. To pump up earnings, Equity Funding began reinsuring fictitious policies. Sales skyrocketed and the reported insurance in force tripled. The industry was amazed at Equity Funding’s ability to turn its program around and show surprising gains while everyone else was experiencing a severe decline.

Unrealistic Goals, Financial Targets, or Expectations Set By Management For companies to grow and progress, it is important for them to have goals and high expectations. However, when management sets goals or expectations for its employees or operating units that are unrealistic, they may be motivating them more toward fraudulent behavior rather than improved performance. In essence, they may be forcing them to choose between failing through no fault of their own or cheating.

Example: William Nashwinter, a young aggressive salesman with Doughtie’s Foods, was promoted to be the general manager of an East Coast warehouse that wholesaled frozen food products to retail outlets. When he did not meet the profit goals Doughtie’s set for the warehouse, he was severely criticized. After several such criticisms he decided to do whatever it took to meet what he felt were Doughtie’s totally unrealistic profit goals. He inflated the monthly inventory balance he sent to Doughtie’s in order to decrease his cost of goods sold and inflate his gross profit. Unfortunately, warehouse performance never improved, and his scheme required him to fabricate ever-larger amounts of inventory to meet his goals. When he finally confessed his wrongdoing, the investigating CPA firm found that in the last year of the fraud, net income was inflated by 39 percent. In essence, Nashwinter decided it was better to be dishonest than to not meet the budget.

There Are a Number of Other Important Company Pressures:

Χ New accounting, statutory, or regulatory requirements -- These could impair the financial stability or profitability of the entity.

• Possible suspension or termination of licenses or operations.

• A high degree of competition or market saturation, accompanied by declining margins. • Rapid changes in an industry -- Some examples are:

o Declining customer demand;

o High vulnerability to rapidly changing technology; or o Rapid product obsolescence.

• Significant additional capital is needed to stay competitive. This takes into consideration the financial position of the entity, including the need for major research and

development or capital expenditures.

Many Other “Red Flags” Appear Due to Management-Related Pressures

• Assets, liabilities, revenues, or expenses subject to significant estimates involving highly subjective judgments or uncertainties -- These may also be subject to potential change in the near term in a manner that may have a financially disruptive effect on the entity, including those involving:

o Ultimate collectibility of receivables; o Timing of revenue recognition;

Chapter 3: Fraud Prevention: Pressures and Rationalizations

o Realizability of financial instruments based on the highly subjective valuation of collateral or difficult-to-assess repayment sources; and

o Deferral of certain costs, such as software development costs. • Heavy dependence on new or unproven product lines.

• Unusually rapid growth or profitability -- This is to be noted when compared with that of other companies in the same industry.

• High vulnerability to changes in interest rates.

• Unusually high dependence on debt -- This takes into account a marginal ability to meet debt repayment requirements, and debt covenants that are difficult to maintain.

• Unrealistically aggressive sales or profitability incentive programs.

• The threat of potential foreclosure or loss of confidence by customers, suppliers, or lenders -- This is a concern when poor financial results are reported.

• Adverse consequences on significant pending transactions -- Some examples include a business combination or contract award, if poor financial results are reported.

• Poor or deteriorating financial position -- This is of special concern when management has personally guaranteed debts of the entity.

• Heavy losses -- Some reasons for heavy losses include failed investments, past operating losses, etc.

• Unusual difficulty in collecting customer’s receivables. • Actual or threatened litigation.

• Severe inventory obsolescence/excessive inventory buildup relative to sales.

• Significant portion of executive compensation represented by bonuses, stock options, or other incentives -- This is of concern when their value is contingent upon the entity achieving unduly aggressive targets for operating results or financial positions over which they have control.

• Management committing to analysts, creditors, and other third parties to achieve forecasts that appear to be unduly aggressive or unrealistic.

• Significant tax adjustments made by the IRS can also lead to more management-related pressures.

• Unrealistic performance standards -- These can lead either to desperation and anger, resulting in dishonesty or “get even” attitudes.

Work-Related Pressures

Pressures can also be work-related. Some of the more frequently encountered work-related pressures are discussed below.

Severe Resentment

Feelings of anger and resentment have caused some perpetrators to compromise their personal integrity. Anger and resentment can build until it eventually dominates feelings, and thinking becomes cloudy. Reason is replaced by a desire to get even or to strike back, caution is thrown