Do we really want to detect accounting fraud?

Sometimes, serious problems in capital markets persist not because we can’t solve them — and not because we need to examine them more thoroughly — but simply because we prefer to leave the problems unexamined and unsolved. So, we stoically endure some of the most toxic trends in finance. Instead of confronting them, we often deny their existence or their gravity, or we vilify sensible solutions that do not align with our ideological biases.

This self-defeating dynamic has already produced some ironic outcomes. We continue to see, for example, a deepening of many of the vulnerabilities that contributed to the historic collapses of Enron and Lehman Brothers. Too-big-to-fail firms continue to grow, despite worries about systemic risk. The hope for fundamental improvements in corporate governance often seems naive these days, as corporate reform remains a bumper-to-bumper crawl toward an unclear target. Unanticipated “flash crashes” and “flash freezes” still cause costly disruptions of trading in our densely wired market.

To this list of our collective failures, we often forget to add our failure (thus far) to reform corporate accounting, the very “language of business” that makes it possible to value assets. Accounting needs a new conceptual framework and a new regulatory and rule-making regime. Specifically, moving toward integrated reporting is essential, since accounting should at least aim to account for all assets and liabilities and all forms of capital. Otherwise, under the current system, the practical value of mandated financial reports will continue to diminish. (Read more here and here)

Further, without substantive reforms, we will continue to struggle with detecting and preventing fraud. Note that, even if they comply meticulously with current accounting standards, public companies can still legally produce financial reports that distort the value of underlying assets. Not surprisingly, misleading accounting remains widespread and costly for all market participants. (Read more)

Several academic researchers have written extensively on this subject (Read more here, here and here). To me, their thesis seems unassailable and impossible to ignore. Still, some pundits are trying to assail or ignore it, with the apparent intent to push it to the margins of public discourse. We can speculate about the motives of these detractors, but here, I’d like to highlight two ways in which these pundits confuse or trivialize the study of fraud while purporting to take it seriously.

1. Sensationalist Fear Mongering

A seemingly harmless article in Fortune magazine last week discusses the evolution of algorithmic “Big Data” methodologies for detecting fraud in financial markets. The article touches on the SEC’s well-publicized renewed focus on accounting fraud. At first glance, the author is only guilty of regurgitating old news. In a far more egregious offense, the author warns us that “fraud detection approaches its ‘Minority Report’ moment”.

In this context, the reference to the 2002 science fiction thriller presumably suggests that the application of data science to the study of fraud represents a moral slippery slope that may result in penalizing people or companies who have not committed a crime. (Recall that, in Minority Report, a specialized police department apprehends criminals based on foreknowledge of three psychics called “precogs”.)

By any reasonable measure, this argument is delusionally paranoid. Minority Report artfully dramatizes the tension between Free Will and Determinism. In the film, a prediction based on presumed foreknowledge results in a verdict, which results in the imposition and execution of a sentence. By contrast, forensic analysis neither delivers carved-in-stone verdicts, nor does it compel anyone to apply automatic penalties. Forensic analysis merely discerns anomalous patterns in behavior or data and points to avenues for further investigation. We have no reason to fear forensic analysis. But we should fear fraud, especially when its perpetrators remain shielded from consequences.

2. Speaking Confidently and Carrying a Limp Stick

Last week, Bloomberg’s accounting blog discussed the continuing lowering of expectations for improvements by accounting standard-setters.

“The road to improved accounting rules seems to be littered with diminished expectations. That appears to be a hard – and everlasting — lesson for the diligent rulemakers at the Financial Accounting Standards Board and its partner in London, the International Accounting Standards Board.”

“Over the last decade, ambitious agendas for transatlantic convergence on accounting principles have been pared back, and pared back again.  The FASB-IASB docket has featured big joint projects aimed at important improvements. However, they included quick-hit convergence efforts, too. Unfortunately, even the quick-hit items hit back. Several big-ticket accounting topics have been put on long-term hold.”

“The FASB member [Lawrence Smith] went on to question the effectiveness of the standard-setting process at FASB. On the aging revenue recognition effort, he noted that revenue reporting will change at some companies, ”but for a very, very significant number of transactions, there’s not going to be a change. And yet, we’ve spent 11 years really trying to fix this issue,” Smith added.”

This survey by a FASB advisory committee makes it clear that the ongoing pattern of regulatory and standard-setting lethargy runs counter to the sense of urgency with which FASB stakeholder view the need for meaningful reforms.

Reasons for Inaction

Of course, this long-running pattern of inaction and bureaucratic half-measures will disappoint anyone who hopes for stronger leadership from guardians of market integrity. Here are a couple of perspectives that may help explain the disconnect.

  • The Relationship Between Corporate Fraud and Investor Optimism (Video) — Academic research suggests that companies commit fraud to appease irrationally exuberant investors. The apparent conclusion is that investor monitoring of corporate accounting will not curtail fraud as long as investors continue to pressure companies to meet aggressive performance targets. (Also see here)

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