Looking the other way: Managers' rationalization of possible frauds

Managers, knowingly or unwittingly, may contribute to employees' frauds by rationalizing questionable situations. 

Bill Smith audited the far-flung plants of a large private corporation for the corporate headquarters. On one trip, he found multiple charge-offs that indicated some vendor contracts were little more than loans to favored dealers. The buck stopped before Smith could examine further. The local executives, auditor, and operations manager returned similar stories that the problem had been taken care of and any reporting would make the company look bad. Their actions kept the finding from making its way into the final report. (1) 

In a company fraud there are often two people involved even if only one is taking the money. Managers often look the other way because of their own sets of rationalizations. The fraud examiner who assesses the manager's role can find important clues to the nature and extent of employee fraud during an examination.

Sarbanes Oxley before and after
The ramped-up regulations and liabilities resulting from the Sarbanes Oxley Act changed the way public companies approach fraud prevention. Controls improved, education and monitoring methods tightened, and audit committees increased scrutiny of company processes. But the act has not put fraud examiners out of business. "Public companies are tremendously improved because of SOX, but I still see fraud perpetrated at private and not-for-profit companies," says Leon A. La Rosa, Jr., CFE, CPA, MST, chair of litigation support services, Gocial Gerstein, LLC, in Jenkintown, Penn. "I'm constantly surprised that nonpublic and even smaller public companies haven't taken up better prevention given all the limelight in the press about fraud."

Obviously, the new regulations haven't eliminated the problem even at public companies. Some people will always be looking for an angle to get a better path for themselves, sometimes at the expense of others. Ken Yormark, managing director of Protiviti, in New York, N.Y., reports the consensus belief that fraud will always be with us. "Controls are only as good as the people in place to monitor them," says Yormark. "Companies also change. The right control today might not be the right control for tomorrow."

Where gaps exist, managers - the monitors of both people and controls - often are the stopgaps. But their rationalization quirks can widely affect their job performances. SOX changed the regulations but the culture of fraud prevention is still in transition. Pre-SOX, many organizations unofficially encouraged a "don't ask, don't tell" type of culture. "The belief used to be 'if it ain't broke, don't fix it'," says Yormark.

I see nothing
Managers looking the other way in hopes of not seeing the frauds indicate a problem culture. A manager with his head in the sand might be a sign for a fraud examiner to spend some time in that department. Donald L. Cameron, CFE, of Fraud Examination Services, LLC, in Overland Park, Kan., tells of a recent phone call from the manager of a large nonprofit in his area. The caller inquired how he could know that some of the projects his organization funded might not be fraudulent like the Kansas City Head Start program that was grabbing local headlines. Called the "poster child for government fraud," local newspapers focused on the fact that the salary for the head of the local program topped that of the federal secretary of education. The Department of Health and Human Services questioned $814,142 in compensation to Dwayne Crompton over the three fiscal years that ended June 30, 2002 . Crompton is executive director of the KCMC Child Development Corp, whose agency oversees 11 Head Start centers in the Kansas City area. KCMC officials also said Head Start funds had been used in the past to pay part of a $600-a-month lease for a Mercedes sport-utility vehicle for Crompton.

Cameron, who spent 22 years in mechanical contracting before creating his firm, simply answered that the caller wouldn't know unless he looked into it. "He promptly thanked me for my time and hung up," says Cameron. "After several more headlines of the Head Start investigation he called back for a proposal."

This manager ascribed to the denial school. If he didn't know about it perhaps it didn't exist. In the not-for-profit world the belief that good people are getting the grant money to do good things also supports looking the other way. "Funders still have to answer the question of how to do proper examinations of grant recipients while not believing that everyone is a crook," says Cameron.

When the manager is the problem
Managers become part of the problem for several reasons. One of the greatest incentives is financial. (Cameron turned down one case when he realized the executive who had requested his services was actually asking for tips on how to commit fraud.) "Some of the worst cases are when the manager looks the other way because they are part of the problem," says Cameron.

A review of the compensation structure of the department might reveal that managers receive bonuses and other rewards based on meeting certain sales or revenue benchmarks. Karl Kasca, CFE, encountered one particularly memorable case from his 16 years as internal auditor for a Fortune 500. One of the company's divisions consistently ranked at the top with accident-free truck drivers. Division managers happily received their regular rewards and honors for a job well done. "When we audited we found the accident reports in the supervisor's desk drawer," says Kasca, now of Kasca & Associates in Pasadena, Calif. Kasca's firm helps fraud examiners to effectively access information and conduct research.

Sometimes the corporate culture supports managers in looking the other way just to keep their jobs. SOX and the whistleblower protections change this somewhat. An analysis of the company's acceptance of fraud found on a manager's watch might yield clues in an examination. "Someone might have to evaluate whether a certain finding is weighty enough to put their entire career on the line," says Kasca.

The willingness to look the other way might be supporting smaller frauds. A purchasing employee certainly knows that she should be dealing with the vendor at the lowest price for equal quality but is getting some personal payback or gift from a higher-priced vendor. "This manager might rationalize that the difference in amounts is not significant in the company's overall expenses," says LaRosa. "If the expensive contract doesn't go over budget the manager has an additionally comfortable rationalization."

For the good of the company
The ACFE's Report to the Nation on Occupational Fraud and Abuse shows that large frauds occur at the highest levels in the organization; upper management in public companies might rationalize that it's good for the company because the fraud, if it's an overstatement, might cause the stock price to appreciate. Obviously, any quarter in which earnings might miss analysts' targets, management has a significant reason to report desired results rather than true economic results. In private companies, managers might report fraudulent financials to prove compliance with debt covenants. "The issue always gets back to the integrity of the people," says La Rosa. "If senior managers tell middle managers that moving expenses forward one quarter is okay because they'll recover it the next, then the middle managers take on that attitude with simple things like travel expense reports."

Even expense reports force managers to choose between strict policy adherence and fudging the facts. Take the situation in which an employee turns in a report that's missing one receipt. The meal in question is a reasonable expense - it was in the town where the employee did business - and the employee is a good worker. A manager who accepts a handwritten receipt that's against the rules acts out of her belief that this one time is good for the company. "A manager that takes out an employee for a small infraction creates a negative situation," says Kasca. "That employee might take that as a rationalization to get back at the company in some other way."

Gauging the tipping point of a manager could be useful information for fraud examiners. Each person brings a certain degree of ethical training and cultural experience to the job. "Managers don't sit down and make a list of the advantages and disadvantages of overriding (employee) policies," says Kasca. "But I'll bet that one could almost make a grid of all the factors and each decision to step over the line would fall within a common set of patterns."

In certain countries and locales, fraud is expected as an essential way of doing business. Managers in these settings must make distinctions but to choose to look the other way is often for the good of the company and not personal gain. "I don't care how good the controls are, fraud is important in certain areas on both an individual and political perspective," says Yormark. "The big multinationals have to spend to educate and monitor, but in some cases they just pull out because in the end the company can't ensure compliance with the U.S. rules."

At the other end of the spectrum, managers at small companies overlook fraud prevention because they lack the employees who can implement procedures. Smaller not-for-profit entities, for instance, often have a single person in the accounting department who handles the bank statements, accounts receivables, and payables. Cameron solved this problem with a local community development corporation by convincing them to share an employee with a similar organization. "The groups both were then able to segregate and rotate duties," says Cameron.

Fraud prevention could get top dollar at not-for-profits if the proposed SOX-like national legislation passes. In an April 2005 hearing, Senate Finance Committee chair, Sen. Chuck Grassley (R-Iowa) encouraged the Nonprofit Panel to keep the proposed legislation on the front burner. "If mandatory compliance passes, it will be a whole new ball game for the not-for-profit world," says Cameron. While SOX has improved fraud prevention measures at public companies, motivated people still will find a way around the rules. The possible range of abuse at not-for-profit and private companies stays just as wide as ever. But a fraud examiner may direct her work by observing the attitude and character of the suspected perpetrator's manager.

Managers looking the other way on one thing might reveal that too many other things are sliding by. In other words, where there's smoke there just may be a raging fire.

1 This fictitious example is used for illustrative purposes. 

Cynthia Harrington, CFE, CFA, is a contributing writer for Fraud Magazine.

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