Wednesday, July 9, 2014

A Fraudster's Paradise

Sam Antar writes about society's vulnerability to fraud. Here are a few points that stood out to me.

On stiff punishments serving as a deterrent to fraud:
...white-collar criminals don't listen to the rhetoric of prosecutors. No white-collar criminal discovers ethical behavior and stops doing crime because another criminal ends up in prison. While white-collar criminals take precautions against failure, they do not plan on ever ending up in prison.
Sam implies that the expected punishment for fraudsters is no punishment. This suggests a need for stronger prevention and detection mechanisms. How about auditors?
Traditional financial statement audits of public and private companies are not designed to find fraud. What accounting firms call an “audit” of financial reports is really a compliance review designed to find unintentional material errors in financial reports by examining a limited sample of transactions.
In discussions I've had with auditors, I get the sense that most would like to do more to focus on fraud, but they feel like such a focus would be too expensive and would essentially price them out of the market. While I'm not completely satisfied with that explanation (e.g., firms could, at low cost, use computerized forensic tools to search for red flags), it suggests a need for either regulatory changes that require auditors to focus more on fraud or increased demand by investors for audits that specifically focus more on fraud. The latter is unlikely to occur as long as most investors continue to believe that audits are focused primarily on fraud.

In fairness to auditors, Sam's point about deficiencies identified via PCAOB inspections omits the fact that the PCAOB does not inspect audits randomly, but instead focuses primarily on the audits it believes have the highest risk of deficiencies. This means that even though 49% of E&Y's inspected audits had deficiencies, we would expect the actual rate at which deficiencies occur to be substantially lower. Even that lower overall deficiency rate may not be that informative about how effectively auditors conduct their audits. Still, that's primarily a distraction from Sam's main point, which is that audits primarily focus on unintentional errors rather than focusing on fraud.

If audits aren't particularly effective in preventing/detecting fraud, what about government agencies?
As a nation, we devote far more resources fighting blue-collar crime or street crime, than we do battling white-collar crime. For example, the NYC Police Department employs approximately 34,000 cops in uniform battling street crime. However, the FBI employs approximately 13,600 special agents, the IRS Criminal Investigative Division employs approximately 2,600 special agents, the SEC employs approximately 3,958 people, and the US Postal Inspectors Office employs approximately 1,500 postal inspectors. The NYC Police Department has more man power directly battling street crime than those four federal law enforcement agencies combined have fighting nationwide white-collar crime.
While it would be nice to have some estimates of the economic cost of white-collar vs. blue-collar crime, Sam's point still serves as a good illustration of the relative lack of funding oriented toward white-collar crime. Right now, the government seems to have outsourced most of the prevention and detection work to the private sector (e.g., auditors). Until standards or market forces change so that those parties increase their focus on fraud, we appear to be living in a fraudster's paradise.