Economic crime: The arithmetic of consequence

In the early 1990s a federal prosecutor told trainee fraud examiners that accountants are not trying to detect fraud. Everything since has proved her right.

The material was an Association of Certified Fraud Examiners training video, part of the syllabus for certified fraud examiners, and the federal prosecutor was Gail Nichols, who had prosecuted the president of the Regina Vacuum Cleaner Company for false financial statements.

Asked about the profession that audits the companies she prosecuted, she said: “Just like lawyers, they’re in there for business. So they’re getting paid by the people they’re looking at … they have to be nice to their client and at the same time investigate their client. And it’s almost a conflict from the beginning.

“Do I think they’re detecting fraud? No. I think they’re trying not to detect it.”

The first quotation is the provocative one. The second is the diagnostic one, and it is the more important of the two.

“I don’t think they’re looking for fraud. I think they’re just trying to verify that the books and records are accurately compiled,” she said.

That is not an accusation of bad faith.

It is a description of a bounded operation:

An audit verifies that the representations reconcile;
A fraud investigation interrogates the relationships those representations create.

They are not the same activity, and only one of them is what auditors are engaged to perform. That was in the syllabus. It was taught.

The following 30 years happened anyway.

An audit of her claim

Waste Management, 1998: Arthur Andersen fined over $7 million for $1.7 billion in fabricated earnings. Before Enron.

Enron, 2001.

WorldCom, 2002: After 13 years of Arthur Andersen tenure.

Xerox: The US Securities and Exchange Commission (SEC) found KPMG allowed the accounting to be manipulated from 1997 through 2000.

HealthSouth: Earnings inflated by $2.7 billion between 1996 and 2002, with a whistleblower writing directly to the auditors in 2000 and the fraud running another three years.

Lehman Brothers: The New York Attorney General alleged that for more than seven years, Lehman engaged in accounting transactions the auditor explicitly approved. Repo 105 [an accounting trick] removed up to $50 billion from the balance sheet at the end of every quarter. Not an event. A calendar.

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Satyam, 2009: In the SEC’s own words, the firms “repeatedly conducted deficient audits” and thereby “enabled a massive accounting fraud to go undetected for several years”.

Toshiba: Profits overstated by ¥151.8 billion over seven years. An accountant at the audit firm spotted an abnormality in the computer business and neither pursued it nor told the rest of the engagement team. Olympus, audited by the same firm, concealed two decades of losses and was exposed not by any auditor but by a chief executive who was dismissed for raising it.

Steinhoff: Deloitte, auditor for almost 20 years; €6.5 billion in irregular transactions across eight of them.

Read:
Why did PwC not identify corruption at SAA?
Tongaat: Deloitte in the firing line
Contents of Steinhoff’s PwC report still unknown

Carillion: Financial years 2013 through 2016, four consecutive audit cycles, each separately engaged, planned and signed. The Financial Reporting Council found the company “was not subject to rigorous, comprehensive, and reliable audits in the three years leading up to its demise”. It collapsed with £29 million in cash against £7 billion in liabilities, months after an unqualified opinion.

And Wirecard: €1.9 billion that did not exist, certified year after year, while a research firm published about it in 2016 and the Financial Times ran documented allegations from 2019.

All of this post-dates that training video.

Why this is not a list of accidents

A single deficient audit is consistent with error.

But error does not repeat in a consistent direction for four consecutive years. It does not recur at the end of every quarter for seven years. It does not survive a whistleblower’s letter and then continue for three more.

An audit is not a continuous act. It is a discrete engagement – planned afresh, staffed afresh, signed afresh, every year. Four consecutive unqualified opinions are four decisions, not one.

And in several matters the sequence is knowledge followed by continuation:

Deloitte’s own internal reports flagged African Bank.
The auditor was found aware of the Repo 105 classification.
The Toshiba accountant saw the anomaly.
The HealthSouth whistleblower wrote to the auditors directly.

In criminal law, intent is not proved by opening someone’s head. It is demonstrated by a repetitive pattern of conduct sustained over time – precisely because error does not behave that way.

Applied to anyone else, that test is uncontroversial. Applied to the auditor, it produces an answer the profession has never had to give.

What it cost (or didn’t)

Across the 11 cases where a published loss figure exists, the itemised total exceeds $305 billion [some R4.8 trillion at the current rate of exchange]. Lehman, the largest bankruptcy in United States history, is excluded entirely, because no single published figure exists for it.

Sanctions and settlements involving auditors in connection with audit failure: approximately $1.5 billion [just under R24 billion].

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That is 0.49% of the losses, and it is generous – three quarters of that $1.5 billion arises in cases whose losses are excluded from the denominator. Matched like for like, the figure is 0.12%.

Read: Auditing giant Deloitte’s R260m Tongaat Hulett settlement ‘pathetic’ – Logan

The perpetrators received between 147 and 181 years of custody between them, depending on how two indeterminate sentences are counted:

WorldCom CEO Bernard Ebbers, 25 years;
Enron CEO Jeffry Skilling, 24 years and four months;
Timothy Rigas (securities fraud), 20 years;
Parmalat founder Calisto Tanzi, 18 years; and
John Rigas (Timothy’s father, securities fraud), 15 years.

No auditor in any of those cases received a custodial sentence.

Read: R2m fine or prison: Former Steinhoff auditor sentenced

And the largest single penalty in the record – $456 million [R7.2 billion] paid by KPMG in 2005 to avoid an indictment that would have destroyed the firm – was for marketing abusive tax shelters. It had nothing to do with auditing anything.

The defence that is not available

There is one ‘respectable’ answer to all of this: that fraud is genuinely difficult to detect, and that auditors are doing a hard thing imperfectly.

It does not hold, and the reason is structural rather than moral.

Fraud operates inside a closed system.

Every fraud is ultimately an entry, and entries balance – not usually, but necessarily, because conservation is the language the system is written in.

A fraud therefore cannot avoid leaving accounting consequences, and those consequences are distributed across the system rather than concentrated where the falsehood was introduced.

Which is why detectability is a question of relating information rather than finding it. The analytics in the Regina Vacuum Cleaner Company case were visible on the face of the statements: receivables from 33% to 43% of total assets, days sales in inventory from 76 to 113, net sales up 110% with no corresponding increase in cost of sales.

And why, at ESM Government Securities Inc, a certified fraud examiner opened the financial statements and saw it in minutes – receivables and payables identical to the dollar, in three of four years. The auditors had missed it for seven. The tax return, showing $90 million in trading losses, and the audit, showing rising retained earnings, had been prepared by the same firm.

Nobody compared them.

That is the shape of it. The information was not missing, and it was not concealed.

It was produced inside the professional environment itself, sat in two places, and the relationship between them was never interrogated.

If fraud is knowable, and not found, then non-detection is not a misfortune. It is an outcome.

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How it actually happens

The temptation is to conclude that auditors are bought.

Mostly they are not – and the real mechanism is worse, because it requires no corruption at all.

Jose Gomez was the partner in charge of the ESM audit, living beyond his means.

The fraudster offered help with his debts – but as the lawyer who unwound the collapse was careful to explain, that was not a payment for doctoring accounts.

Gomez and his team simply missed the fraud in year one.

In year two, when he learned of it, he was asked whether he really wanted to tell his partners he had blown the audit, and recall the statements he had already signed.

He served 12 years. “Every young accountant and lawyer, all professionals, we are, from day one, adverse to failure … Very hard to reverse that emotional trend and say, I messed up, boss.”

No bribe. No conspiracy. A first-year failure, and the cost of admitting it.

This is why the corruption explanation is the comfortable one.

If fraud survives an audit because somebody was paid, the remedy is to remove that person.

But if it survives because professionals are structurally disinclined to reopen a prior conclusion, to cross an information boundary, or to treat an anomaly as an investigative problem rather than a reconciling item, then there is no individual to remove.

The first failure may be accidental. Persistence is a different thing, and it does not require anybody to be dishonest.

That is the whole mechanism, and it was on the syllabus in the early 1990s, alongside a prosecutor saying plainly that the profession was not looking.

Thirty years of collapses later, the question is no longer whether she was right.

It is what it says about a profession that taught her answer to its own trainees, and changed nothing.

* Losses, sanctions, settlements, and sentences in the major financial-statement frauds of the last 25 years – a visual overview by the author – can be seen here.

Bart Henderson is a veteran fraud risk specialist and forensic investigator with nearly three decades of experience at the highest levels of financial crime detection, investigation, and litigation support across South Africa and beyond.

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