Detecting fraud: will the new rules help? Sarbanes-Oxley compliance is raising questions about the relationship between internal and external auditors and increased audit costs, Financial Executives Research Foundation (FERF) finds.

• Author: Sinnett, William M.
• Position: Fraud

On Dec. 9, 2003, Parmalat Finanziaria S.p.A.'s founder Calisto Tanzi and his son Stefano told executives from private equity fund Blackstone that the Italy-based international food products company's financial accounts were inaccurate. Before the end of the month, Tanzi admitted to diverting 500 million euros (about $640 million) from Parmalat's funds to finance other parts of the business controlled by his family. Assets of Bonlat, a Parmalat subsidiary, were said to include a $4.6 billion Bank of America account, but it was later discovered that the account did not exist. With that, Parmalat became the latest corporate fraud to make the headlines, with its chairman allegedly the chief perpetrator.

This newest headline-grabbing fraud, like others of its ilk, involves senior management. These days, a fraud has to be really noteworthy to garner headlines; after all, it's competing with wars, terrorists and tragedies. But there may be some statistical rationale to the link with senior executives. An academic paper published in the June 2002 issue of Critical Perspectives in Accounting notes that the CEO was involved in 70 percent of the 276 frauds that took place between 1987 and 1999, based on an analysis of enforcement actions taken by the Securities and Exchange Commission, and another 20 percent of the frauds (for a total of about 90 percent) involved other members of senior management. The paper, "Defrauding the Public Interest: A Critical Examination of Reengineered Audit Processes and the Likelihood of Detecting Fraud," was authored by Charles P. Cullinan and Steve G. Sutton.

"Senior management is responsible for establishing a reliable system of internal controls. Either management or internal audit can detect the small, 'petty cash' frauds, but frauds by senior management are a different problem," says Ellen H. Masterson, global leader of Assurance Methodology for PricewaterhouseCoopers LLP. Masterson referred to a July 2002 article in The Wall Street Journal, "Auditors' Methods Make It Hard to Uncover Fraud by Executives," which cited the results of the Cullinan/Sutton academic paper. "The gist of the article," she says, "was that external auditors' methods were not designed to detect financial reporting fraud committed at the executive levels in an organization."

The apparent surge in executive-level fraud has raised key detection questions. If auditors--both internal and external--are expected to discover such fraud, how much more...