Michael Goldman & Associates, L.L.C. - Consulting
& CPA Services
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Goldman's
Critical Support -- Summer 2002
Who's
Watching the Store?
Why did Enron's bankers help keep the sham alive long after
they should have pulled the plug? Why did in-house and outside lawyers condone
corporate behavior that seems so obviously illegal? Similar questions are being asked in the cases of Cendant,
Anicom, Global Crossing, Waste Management, Mercury Finance, CUC International,
Sunbeam, Leslie Fay, Xerox, Tyco, Rite-Aid, and others. Business people are asking these questions not so much to lay
blame, but to figure out how this kind of thing can happen, and how to prevent
it from happening again. More importantly, how can you prevent this kind of thing from
happening to the companies, small and large, that you deal with? Pressure on small-business managers Enron-like activity, albeit on a smaller scale, occurs at
closely held companies more often than you might think. Most fraud starts not
with greed, but with pressure – pressure to maintain growth rates, pressure to
meet revenue projections, pressure to pay managers high salaries and perks,
pressure to please lenders and, to a lesser degree, shareholders. In family run companies the pressure often comes in the form
of trying to impress siblings or in living up to mom and dad’s expectations.
This problem can be particularly acute in family businesses, where
strained family relations may compound other corporate pressures. Understand how fraud begins The key to preventing
management fraud, or at least nipping it in the bud before it consumes the
company, is to rely on a strong oversight presence: independent directors, an
oversight committee, and/or concerned creditors. It is important that they
understand how fraud starts and spreads throughout an organization. That
understanding will help them not only to recognize fraud as it begins to emerge,
but also to recognize an environment that breeds fraud. Fraud most often starts
out small, in fringe areas of the business or in accounting, and steadily grows.
Often it is intended as a one-time, quick fix to an immediate problem. By the
time it grows big enough to keep the perpetrators awake at night, they are in
too deep and cannot stop, because that would mean instant exposure. Borrowing from the
future Fraud often begins when a
company has bank debt with the typical “thou shall” and “thou shalt not”
covenants. Then there’s a setback which causes management to miss a projection
or covenant figure – revenues drop off, costs spike, margins slide, etc. –.
Hopeful that the problem will be rectified by the next reporting period,
management “borrows” a little bit of next period’s improved results.
Unfortunately, the next period is a little worse, and management, instead of
being able to repay last period’s obligation, decides to “borrow” a little
more from the future. Managers don’t feel they’re doing anything so terrible
until after a few rounds of this, when they realize that the business is not
improving and that they have no exit strategy and must continue the ruse. Borrowing from future
periods is fairly simple: accelerate shipments, keep reporting periods open
longer, reduce reserves, recognize revenue on anticipated orders, recognize
revenue on consignment sales, manipulate accounts receivables, delay expense
recognition, improperly value transactions, falsify inventory in transit or on
trucks, overvalue inventory, improperly capitalize expenses, book related-party
transactions, and create phony inventory or sales. More than one person may be
involved, but in larger organizations each accomplice rarely sees the whole
picture. Watching the store through opaque windows? Where are the overseers while this is happening? In larger
companies with public auditors, the CFO or controller may have come from the
audit firm. He knows what they focus on and what they tend to miss -auditors
only look at very small samples. His
camaraderie with the auditors helps to smooth over any suspicions that they do
uncover. In privately held firms, bank auditors and outside CPAs are
unlikely to catch fraud because they tend not to take time to learn the
business, and they accept easy explanations to explain away the irregularities
they find. The personal roots of fraud People who cut corners, who are excessively optimistic, who
have too much at stake to lose, etc., are all people prone to starting out with
a little "harmless" manipulation (which blossoms into big, destructive
fraud). Overwhelming personal pressures – medical problems or
impending divorce, for example - can help promote a fraudulent environment. Lack
of budgeting and planning can add to the frustration. Most business people are
inherently honest and not easily corruptible – the pressure on them has to get
really overwhelming for fraud to get started. Typical entrepreneurial personality characteristics –
control-obsession, passion, drive, optimism, aggressiveness, commitment,
salesmanship, single-minded focus, tolerance for ambiguity and uncertainty,
creativity, etc., can combine with external pressures to produce an explosive
mix. Independent oversight Director oversight committees or concerned creditors need to
be genuinely independent, yet still understand the company well enough to detect
irregularities. Most importantly, they need to understand the company
environment and what pressures exist. The more pressure management is under to
perform, the more management needs to be watched. Company overseers must be independent, knowledgeable, and
willing to work. They must be willing to stand up to managers who feel
tremendous pressure to perform. They need a clear and candid flow of information
from people in the company who can tell them what is really going on -
independence notwithstanding. Open communication and information flow are not
just good management practices; they are also good fraud prevention techniques. In a family business especially, the active presence of a
board of directors and non-family managers is crucial to fraud prevention.
Family firms tend to be very good at operating, marketing, and manufacturing,
but relatively poor in long-range strategic planning. Access to experienced
managers and advisers is often the most effective way for owners to overcome
their resistance to strategic planning, detailed budgeting, and rigorous
financial reporting. Besides being
good management practices, these are also good fraud prevention tools. Make sure management communicates openly, reports accurately
and thoroughly, and employs controls to detect misreporting. The old saying,
“An ounce of prevention is worth a pound of cure,” has seldom been more true
than in corporate oversight.
© Michael Goldman 2002 For more information, please go to www.michaelgoldman.com Editorial material in these newsletters is intended to be informative, and should not be construed as advice. For advice on any specific matter, please consult your financial or legal adviser.
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