In this paper, we provide a brief overview of fraud. We explain what fraud is and the seriousness of the fraud problem.
The cost of all frauds–especially financial statement fraud–is extremely high. For example, when a company manipulates its financial statements, the market value of that company's stock usually drops considerably, sometimes by as much as 500 times the amount of the fraud. As an example of the cost of financial statement frauds, consider what happened to the NASDAQ following revelations about corporate wrongdoing during the period 1996 to 2002.
Studies have shown that the NASDAQ composite increased from about 1100 to 5049 during the period 1996 to 2000, or nearly 400%. With Enron, WorldCom and other financial statement fraud revelations beginning in 2000, the NASDAQ stock exchange dropped to 1,114 or 78% from its previous high. The effect of the corporate scandals on the NASDAQ far exceeded the drop caused by the September 11, 2001 World Trade Center Disaster. It has been estimated that the cost of the Enron and WorldCom corporate scandals alone reduced the overall United States Gross Domestic Product by $42 billion in just the first year following the discovery of fraud.
WorldCom, Enron, Conseco, Global Crossing and Adelphia, were companies associated with massive financial statement frauds. In addition, seven of the top 12 bankruptcies in U.S. history occurred in either 2001 or 2002. In total, there was a record 186 companies with a combined $369 million in debt that filed for bankruptcy in 2002.
The High Cost of Fraud
When a financial statement fraud occurs, the decline in market value and lost revenue for a company can be astronomical. When a fraud against a company occurs, such as when an employee steals money, the cost can be equally destructive. Consider a simple example. Assume a company has $100 in revenue (it could be $100 million, $100 thousand, etc.) Also assume that it has operating expenses of $90 and operating profit of $10, resulting in a 10 percent profit margin. If someone commits a fraud of $1, operating profit is reduced to $9. Because this company's profit margin is 10 percent, it must generate approximately 10 times the amount of the fraud or an additional $10 of revenue to restore net income to $10 (because $9 of the $10 of additional revenue would be incurred in additional operating costs). These figures do not include litigation costs, loss of additional future sales and company image, or other negative effects of the fraud.
To understand how dramatically fraud can affect a company, consider the case of a large automobile manufacturer that, a few years ago, had a $436 million dealer fraud. At the time, the company's profit margin was approximately 10 percent. At this profit margin, the company needed to generate approximately $4.36 billion in additional revenues to restore net income to its pre-fraud level.
The executives of this victim company realized that because of the high cost of the fraud, they didn't just have a fraud problem; rather, they had a business problem. They could either work to stop these types of frauds from occurring in the future or they could make and sell 218,000 additional vehicles to offset the cost of the fraud. They realized that the result on the bottom line was the same.
Consider how much this fraud (and another $70 million fraud experienced by the same company later that year) put this automobile company behind its competitors. While this automobile company was spinning its wheels to restore stolen profit, its competitors without significant frauds were increasing their profits and investing capacity. A similar problem occurs around the world in countries with high rates of corruption. Because of the high cost of fraud and corruption, in many ways, high-corruption countries are spinning their wheels while other countries with lower amounts of fraud and corruption are increasing their per capita incomes, reducing poverty and hunger, and becoming more prominent members of the world economy. For corrupt countries, the problem is even worse because investors don't want to place capital in economies with high rates of corruption.
Types of Fraud
One way to classify fraud is to focus on why fraud is committed. Motivations may vary, but all frauds involve the same elements of deception, confidence and trickery. They involve someone making an intentional representation to someone about a material fact that is false (thus conning the victim) which is believed and acted upon to the victim's damage. Every fraud has three elements: (1) theft act, where the perpetrator steals the money or other assets, (2) concealment, where the perpetrator tries to hide the fraud so it won't be detected and (3) conversion, where the perpetrator converts whatever was taken into cash or enriches him or herself indirectly and then uses the ill-gotten gains for personal enrichment. It is the concealment element that distinguishes fraud from most other crimes. When a person robs a bank, for example, there is no attempted concealment. The entire event is caught on camera and is traumatic for those present. There is little question that a crime has occurred. With fraud it is not always clear that a crime was committed. A person's lifestyle may increase, money may be missing, or the financial statements may be misstated, but these symptoms do not guarantee that fraud has occurred.
Fraud is a cancer that eats away at society's productivity. Its occurrence reduces the effectiveness and efficiency of economies and cost individuals and organizations tremendous amounts of money. Even with these high costs, however, fraud is a problem that can be minimized within organizations.