Waving the red flag

Survey examines correlation between
ethical environment and fraud in co-ops

By Tommie Singleton, Frank
Messina and Richard Turpen

Editor’s note: Singleton is an assistant
professor, Messina and Turpen are associate
professors at the Department of Accounting
and Information Systems at the University
of Alabama at Birmingham. They can be
reached at (205) 934-8820, or by e-mail
at: fmessino@uab.edu .


raud and ethics are subjects of great concern to everyone involved in business. Conservative estimates place the cost of fraud to American businesses in the billions of dollars.

Several techniques, guidelines and tools have been created and promoted to help businesses better detect fraud. Yet all of these advances and high-tech tools cannot compensate for the oldest accounting technique of all for fraud: a sound ethical environment for the cooperative. This article examines the correlation between ethics and actual instances of fraud, based on a survey of cooperatives, identifying the “red flags” that precede fraudulent activities.

Fraud & ethics Over the past 40 years, the accounting community has increased its efforts to detect fraud. Recent accounting scandals have caused Congress and other regulatory boards to expand the responsibility related to the detection of fraud.

Researchers have produced a wealth of empirical research related to ethics and fraud. Some of this research provides insights into the role ethics play in fraud and fraud detection.

A new report, “Landmark Study on Fraud in Financial Reporting,” provides many insights into 200 randomly selected cases of alleged financial fraud investigated by the Securities and Exchange Commission (SEC) from 1987 to 1997.1 Published by the Committee on Sponsoring Organizations, a research group of accounting associations, the study results indicate that: A previous fraud study on cooperative fraud funded by the Rural Business-Cooperative Service of USDA Rural Development, KPMG and the National Society of Accountants Accountants of Cooperatives (NSAC) revealed that weakening societal values and weak ethics policies were causes of concern for cooperatives.

Focusing the board and management’s attention on fraud and developing or revising ethics policies or codes of conduct is essential to a solid foundation for internal controls and fraud prevention or detection. Data from the U.S. Sentencing Commission shows that an effective ethics program can prevent an organization from being prosecuted and help reduce fines in federal cases involving employee wrongdoing.

Fraud & ethics research study
A recent survey funded by USDA was conducted to gather empirical evidence related to ethics and actual instances of fraud. The study reveals that an appropriate ethical environment in cooperatives can provide a foundation for preventing fraud and for building effective internal control systems.

The survey instrument asked cooperatives various questions about ethics and actual instances of fraud. A total of 484 cooperatives participated in the study, of which 209 reported having experienced actual or suspected occurrences of fraud. Loss estimates for a single incidence of fraud ranged from less than $50 to $2.5 million. The largest accumulated loss disclosed by a single cooperative for all types and occurrence of fraud totaled approximately $5 million.

Data analysis
When asked if their cooperative had a code of ethics, 49 percent said “yes,” 48 percent said “no” and 3 percent were not sure (see figure 1). Interestingly, when asked if the cooperative provided ethics training, 80 percent of the respondents said “no” (see figure 2).

In addition, 95 percent of the cooperatives stated that they had no person in charge of monitoring ethical matters.

Internal controls & environments
The survey results also indicate that most cooperatives believe that they have relatively strong internal controls and control environments. Using a scale of 1 (highly ineffective) to 5 (highly effective), the cooperatives were asked to rate their own internal controls and control environments. The results for the ratings of internal controls (average rating of 3.99) and the control environments (average rating of 3.90) indicate that most cooperatives view themselves as having effective controls to help prevent fraud. The cooperatives also rated their degree of vulnerability of fraud as being very low, with an average rating of 1.35 (using a scale in which 1 equals “very low,” to 5, being “very high”).

The reasons given for occurrences of fraud are quite interesting, given the cooperatives’ view that most are not vulnerable to fraud. “Insufficient internal controls” was the top reason given for fraud (table 1). Ranking second was “collusion, management override of internal controls and lack of active director control over management.” Ranking third was “weak ethics policy or code of conduct.” These findings are consistent with other fraud and ethics studies. Thus, the ethical environment appears to hold up as the foundation for sound internal controls and prevention of fraud. Likewise, a weak ethical environment, such as lack of training or not even having an ethics policy, has the potential to weaken internal control systems and lead to fraud.

Red flags & instances of fraud
Another objective of this study was to find out what cooperatives would identify as “red flags” that indicated fraud was present (see table 2). The top four red flags reported were: unusual activity, unexplained losses, poor internal controls and changes in the lifestyle or behavior of an employee or management. Unusual activity and unexplained losses hint at the possibility that the fraud could have been prevented.

The next two indicators (poor internal controls and change in lifestyle or behavior of the perpetrator) are no surprise, in that they have been found to be red flags in many prior research studies on fraud. Poor internal controls lead to fraudulent activities. Remember, the same cooperatives rated their internal controls as being effective. Apparently, this is a manifestation of “the other person” syndrome, where cooperatives always think their internal controls are adequate while the other cooperative is the one with problems. This view of fraud and ethics must change.

Cooperatives also need to make a concerted effort to use professional skepticism and something more than a paper inquiry to ascertain the lifestyle and behaviors of key employees and managers in cooperatives. Personal financial pressure, vices (drugs/alcohol), being disgruntled, work pressures, unexplained working hours, extravagant lifestyles, severe depression and employees living beyond their means can all signal fraudulent activity.

Conclusions
Fraud and ethics continue to be important business issues. Personal ethics and the ethical environment of the cooperative both play a fundamental role in preventing fraud and strengthening internal controls. Cooperatives need to stress ethics.

This study found that cooperatives have problems similar to those found in all types of businesses, no matter the type of entity. The results also lead to a set of red flags that should be identified and appropriately addressed by cooperatives.

This research provides evidence that developing a corporate culture that stresses honesty and scrupulous behavior is not only the right thing to do, but produces real savings to the cooperative as well. Additional guidance to help prevent fraud can be found in the report “Management Antifraud Programs and Controls,” available at: www.aicpa.org/download/antifraud/SA S-99-exhibit.pdf.

References
  1. AICPA. COSO Releases Landmark Study on Fraud in Financial Reporting, March 26, 1999.
  2. Messina and Turpen “Fraud Prevention and the Management Accountant: Back to Basics. Management Accounting, 1997, February. 34- 37. Reprinted in Cooperative Accountant, 1997, Fall. 72-78.
  3. Ponemon, L. ‘Effective’ Ethics Programs. Management Accounting, 1995, December, 22.




























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