Why Financial Frauds Occur

Think back to the six or nine months when the stock market was in an absolute free fall, say beginning last fall and continuing through this spring.

During that time, how many of you opened up your 401(k) statements as soon as they came in, just to see how badly you were doing?  And how many of you just threw them in a drawer unopened, thinking “I know it’s in the tank; I just can’t bear to look.”

Count me as one who did the latter, and I know a lot of my friends did the exact same thing.

Turns out–no surprise–that’s human nature.

Interesting op-ed in today’s NYT about “accounting anxiety.”

A 2005 study by Lloyds Trustee Savings Bank of Britain showed that accounting anxiety has led to “balance denial syndrome,” in which bank customers so fear being in the red that they systematically ignore their bank statements.

C’est moi.

The author, Jacob Soll, tells his own personal tale of woe.

I myself was reduced to a nervous wreck last April trying to figure out my taxes, even though I had just finished writing a study of the history of accounting. As I waited in my accountant’s office, I realized why I had lost sleep the night before: for the first time in a year, I had to make a reckoning not just of my place in the financial meltdown, but also in my own economic universe; my successes, failures and ultimate weaknesses. I had spent too long off the books, and I couldn’t face it.

And this conclusion.

the fear of bad news often leads to bad accounting.

I’ve known business owners like this.  They know they’ve had a down year.  They know cash flow’s a little tight, sales are a bit down, and they haven’t been able to really cut back on expenses.  But they’ve “spent too long off the books,” and maybe their internal books aren’t so great to begin with.  So the first time they see financial statements that get close to GAAP, they panic.  ”Holy cow!  I knew things were bad, but you’re telling me I really lost $2million last year?”

That’s the moment you complete the fraud triangle.

Remember that management always has opportunity, it’s called management override.  What they’re usually missing is motivation and rationalization.

My hunch is that the shock of seeing the real numbers for the first time, the cold, detached reality of the company’s fortunes–that shock is what makes them think about subtle and not so subtle ways to make those numbers look better.

I still think that most owners won’t be stuffing their inventory boxes full of bricks or committing outright frauds.  But they will reconsider all those estimates in their financial statements, and they’ll look for ways to tweak their assumptions to move the numbers to a more favorable light.

This has to happen, right?  It’s human nature.

1. Stewartre Says:
   November 23rd, 2009 at 1:32 pm

   I’ve always thought fraud was just human nature (see my blog post from a couple months back at http://www.accountingnation.com/post/Fraud-is-Human-Naturee280a6So-Police-Your-Ranks!.aspx)

   Glad to have company in my assessment. Doesn’t HAVE to happen, but certainly increases the propensity for it happening. Good read. Thanks for the insight.

   Robert
   AccountingNation.com

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