R E S P O N S I B I L I T I E S & L B A D E R S H I P

c o r p o r a t e g o v e r n a n c e

Comorate Governanceand the Forensic AccountantBy Vinita Ramaswamy

Recent corporate accounting scandalsand the resultant outci7 for trans-parency and honesty in reportinghave given rise to two disparate yet

logical outcomes. First, forensic account-ing skills have become crucial in untan-gling the complicated accounting maneu-vers that have obfuscated financial state-ments. Second, public demand for changeand subsequent regulatory action hastransformed corporate governance.Increasingly, company officers and direc-tors are under ethical and legal scrutiny.Both trends have the common goal ofresponsibly addressing investors' eonccmsabout the financial reporting system.

The failure of the corporate communi-cation structure has made the financialcommunity realize that then: is a great needfor skilled pmfessionals that can identify.expose, and prevent weaknesses in threekey areas: poor corporate governance.Hawed internal controls, and fraudulentfinancial statements. Forensic accountingskills are becoming increasingly reliedupon within a corporate reporting systemthat emphasizes its accountability andresponsibility to stakeholders.

Poor Corporate Governance andAccounting Failures

The scandals of the last few years ciuiicas a sh(x:k not just because of the enormityof failures like Enron and WorldCom, butbecause of the discovery that questionableaccounting practice was fai" moi"c insidiousand widespread than previously envisioned.A definite link between these accounting fail-ures and p(X)r corporate govemanee is begin-ning to emerge. Adelphia, for example,was given a very low 24% rating byInstitutional Shareholder Services on its cor-porate governance score. In Eun^ . Pannalat

and Royal Ahold ranked in llic lx)tt(.)m tjuiu-tile of compiinies in the index provided byGovernanceMetrics International. TbeCorporate Eibrary had issued early failurewarnings on WorldCom and Enron. Anincreasing number i.i\' researchers are findingthat ptKjr corporate governance is a leadingfactor in poor performance, manipulatedfinancial reports, and unhappy stakehold-

ci s. CorjioratioTis and regulatory b<Klies are

now trying to analyze and correct anyexisting defects in their reporting system.

Problems Within the CorporateReporting System

The interests of investors and other stake-holders are usually protected by a three-tiersecmity system. At the top level is the eom-

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pany's governance code, which is directedtoward enfon:ing company policies, achiev-ing company objectives, monitoring compa-ny pedbmiance. and ensuring adequate dis-closure of the company's activities. At theother end is the reporting system regulatedby public iuid private institutions such as theSEC. the PCAOB, and FASB. which sub-ject public companies to acct>unting anddisclosure standards, iind their auditors toaudit, independence. ethic:il. :ind quality con-trol stantlaitls. Linking the two extremes isa company's system of intemal amtnil, whichprovides n^sonable assurance on the effec-tiveness and efficiency of operations, the reli-ability of finiinciiil reporting, luid complimicewith applicable laws and regulations.

This system, however, seems to havebeen inadequate in many companies. Ascorporations scramble to realign their inter-ests with those of their stiikcholdcrs. threemain areas of weaknesses are emerging:

iMck of a weU-developed and implementedpolicy of corporate governance. The prima-ry goal of corporate goveniiince is tt) enhancethe value of a company through ethical behav-ior, espousing a jxilicy of openness and fair-ness iind ensuring informed decision makingthmughoul the company. Unfortunately, thecenter of corporate ethics—the board of direc-tors—in certain cases bccaine a magnet forunethical practices. Blinded by the glare of arapidly growing sttx:k market, pressured bystockholders for ever-increasing retums, andled by executives seeking to maximize bonus-es based on stock performance, certain boardsof directors iuid audit committees failed toconstrain "creative" accounting to keep uptheir eamings numbers. It must have seemedto some directors that the investing public real-ly did not care about issues sueh as execu-tive compensation, as long as they made theirdouble-digit returns. The ratio of executivepay to that of the average worker balloonedto 600 to ! in 2(XX), from 100 to 1 in 1990.Oosed, entrenched boaitLs magnified the pitib-lem as directors rewarded themselves for"quality" performance until, finally, the bub-ble burst.

Lack of honesty and transparency inreporting. The financial reporting standardsin the United States are the most highly spec-ified in the world. But falling st(X'k market.s,corporate failures, dubious accounting prac-tices, abtises of corporate power, iuid crimi-nal investigations indicate that the system isunder stress. Some corporations have grown

dramaticiilly through acquisitions funded byinllated stock prices ;ind promises of an evenbrighter future. In others, it seems as if thechecks and balances that shexild protect share-holder interests were pushed to the side, driv-en by pursuit of the bottom line.

It has traditionally been an auditor'sresponsibility to express an opinion onwhether financial statements are present-ed according to GAAP. Contrary to theexpectations of many in the public, theauditor does not have an absolute duty touncover fraud, although SAS 99 prescribessteps for auditors to take in order to ensurethat they have planned and implementedtheir audits in a way that responsiblyaddresses fraud considerations.

An ineffective and inefficient system ofinternal control. A good system of inter-nal control will usually help a companyachieve its objectives of profitability andminimize loss of resources. Intemal con-

agement. This could be the key to pre-venting future meltdowns, and to guaran-teeing the two important qualities of cor-porate reporting: transparency and honesty.

The Connecting LinkInitially, forensic accountants were used

by government agencies, such as theCIA. the EBl. and the IRS, to uncoverand investigate fraud. They became finan-cial detectives, independent expertsemployed by management to uncoverfraudulent financial reporting and misap-propriated assets. In the current reportingenvironment, forensic accountants are ingreat demand for their accounting, audit-ing, legal, and investigative skills. They canplay a greater role in coordinating compa-ny efforts to achieve a cohesive policy ofethical behavior within an organization.

The definition of forensic accounting ischanging in response to the growing needs

Forensic accountants can play a

greater role in coordinating company efforts to achieve a cohesive policy

of ethical behavior within an organization.

trol cannot, however, change an inherent-ly weak management system or provideabsolute assurance as to the reliability offinancial reporting.

Companies are now facing increasinglevels of legal, regulatory, and economicreporting requirements, because of theSarbanes-Oxley Act of 2002 (SOA).Companies are spending millions of dol-lars examining their existing systems, andadopting or improving their governanceand internal controls to meet the stan-dards set by SOA sections 403 and 404.

In today's rapidly changing businesslandscape, it is now necessary for accoun-tants and companies to step away from thetraditional approach that emphasized com-pliance with GAAP. and to focus on diestudy and investigation of the traitsunderlying corporate behavior and man-

of corporations. Bologna and Eindquist(in Fraud Auditing and ForensicAccounting, 1995) defined forensicaccounting as "the application of finan-cial skills, and an investigative mentalityto unresolved issues, conducted within thecontext of rules of evidence. As a disci-pline, it encompasses financial expertise,fraud knowledge and a sound knowledgeand understanding of business realityand the working of the legal system." Thisimplies that the forensic accountant shouldbe skilled not only in financial account-ing, but also in internal control systems,the law, other institutional requirements,investigative proficiency, and interper-sonal skills. Corporations can rely onthese skills for developing a consistentsystem of corporate governance, dissem-inating such information within and out-

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side the company, ensuring that gover-nance policies and objectives are inter-woven into the intemal control sy.stem.setting up fraud prevention systems, andinvestigating any existing fraud.

Core KnowledgeA forensic accountant is expected to be

a specialist in accounting and financial sys-tems. Yet a-s companies continue to growin size and complexity, uncovering fraudrequires a forensic accountant to becomeproficient in an ever-increasing number ofprofessional skills and competencies.Here are some of the broad areas of use-ful expertise for a forensic accountant:

• An in-depth knowledge of financialstatements, and the ability to critically ana-lyze thenL These skills help forensic accoun-tants uncover abnormal patterns in account-ing information and recogni/e their source.• A thorough understanding of fraudschemes, including but not limited toasset misappropriations, money laundering,bribery, and corruption.

• The ability to comprehend the intemalcontrol systems of corporations, and to setup a control system that assesses risks,achieves management objectives, infomisemployees of their control responsibilities,and monitors the qtiality of the program sothat corrections and ehiinges can be made.

• Proficiency in computers iind knowl-edge of network systems. These skills helpforensic accountants conduct investigationsin this era of e-banking and computerizedaccounting systems.• Knowledge of psychology. In order tounderstand the impulses behind criminalbehavior and to set up fraud preventionprograms that motivate and encourageemployees.• Interpersonal and communication skills,which aid in disseminating infonnation aboutthe company's ethical policies and helpforensic accountants conduct interviewsand obtain crucially needed information.

• Thorough knowledge of a company'sgovemanee policies and the laws that reg-ulate these policies.• Command of criminal and civil law.as well as of the legal system and courtprocedures.

With this background, the forensicaccountant is distinctively positioned toexplore the design of corporate govemaneesystems, the role of the financial reporting

system in corporate governance, the effectof the govemanee board on employee andmanagerial behavior, and the efficacy ofthe intemal control system.

A Broad RoleCompiuiies need a centralized program

and an established system to measure andmonitor intemal controls' effectiveness andthe lilignment between corpomte govemanee,intemal control, and exiemal reporting activ-ities. Many an; setting up govemanee offi-cers or govemanee committees to meet thedemand for corporate integrity. The gover-nance committee must be active in everyarea of corporate activity to ensure that thecompany is operating as a synergistic whole.As part of the governance committee, aforensic accountant can miike a significantcontribution in each of the ftjilowing areas:

Corporate governance. With a strongbackgrotind knowledge of the leg;U and insti-tutional requirements of corporate gover-nance, a forensic accountant can help for-mulate and establish a comprehensive gov-emanee policy that: ensures an appropriatemix of management and independent direc-tors on the board: sets out the appnipriateresponsibilities of the hoaid and the auditcommittees; has a fair allocation of powerbetween owners, management, and theboard: and ensures there is a company codeof ethics for employees and management.Ethical behavior is reinforecd when top man-agement shows, through its own actions, thatqLiestionable behavior will not be tolerated.

Preventing fraud. Forensic accountantsunderstand that the best way to prevent fraudis to establish an efficient conti'ol systemthat encompasses: a good contn l environ-ment determined by management's philos-ophy of ethical behavior and strong corpo-rate govemanee policies; a superior account-ing system that ensures the proper record-ing, classification, and reporting of all rele-vant tr<uisactions: and strong pnx:cdunil con-trols that provide for safeguarding ofassets, proper authorizations, audit mecha-nisms, and proper documentation.

Creating a positive work environment.A good fraud prevention program alsoaccompanies a positive work environmentwhere highly motivated employees are nottempted to abuse their responsibilities.Forensic accountants can ensure that gov-emanee policies are lomiulated to avoidhigh-risk environments where manatiemcnt

is apathetic, pay is inadequate or too high,there is a serious lack of proper trainingand compliance, or there arc unreasonableprofit and budget goals, it is also necessaryto have well-defined hiring policies thatresult in honest, well-qualified employees.

Establishing effective lines of com-munication. Communication is a keyclement in ensuring that employees andother stakeholders are aware of their rightsand responsibilities. Effective communi-cation (as defined by Committee ofSponsoring Organizations of the TreadwayCommission, COSO) must flow not justfrom the top to lower levels, but alsoacross employee lines of responsibility.Forensic accountants can support the dis-semination of the required informationabout govemanee and ethics policies tointerested parties within and outside theorgani/ation. Adequate reporting is alsonecessary to meet the compliance require-ments of the SEC and the stock markets.

Vigilant oversight. Any system needsto be constantly monitored and evaluatedto make sure that it is functioning well. Aforensic accountant can monitor not onlycompliance at the top levels of corporatepower, but also management proceduresand employee activity. Information gath-ered as a result of the monitoring can beused to readjust and reformulate gover-nance, ethics, and control policies.

Establishing eonsequenees. Fraud deter-rence should also include an expectation ofpunishment. The forensic accountant canhelp in creating policies that clearly statethe company's intent to take action againstany criminal activities, and that such actionwill apply to all levels of employee.

Fraud investigations. A forensic accoun-tant can ensure the integrity of financial state-ments by actively investigating for fraud,identifying areas of risk and associatedfraud symptoms, pursuing each anomalyaggressively, and delving into the minutestdetails of accounting and finiincial anomalies.

By helping companies prevent and detectfraud, the forensic accountant's role can eas-ily evolve into a key component in the cor-porate govemanee system. Q

Vinita Ramaswamy, PhD, is an associateprofes.sor of financial ami forensic account-ing at the University of St. Thomas,Houston. Te.xas.

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