Faced with changes in business ethics and environments, auditors are being called upon to step up to a new standard of fraud detection. One way to facilitate discussions and communications in this area is to use the 3Cs model. The 3Cs represent broad categories of reasons why fraudulent financial reporting occurs.
Explanations of the 3Cs and how to use the model are provided in an article in the current issue of "The Internal Auditor." Highlights:
- Conditions. Conditions are the motivations and pressures to engage in financial statement fraud. In recent accounting scandals, these conditions have included pressures on corporations to meet analysts' earnings forecasts. Executives committed illegal actions to mislead users of financial statements about poor or less-than-favorable financial performance.
- Corporate structure. An organization's corporate structure can create an environment that increases the likelihood that fraudulent financial reporting will occur. Attributes of the corporate structure most likely to be associated with financial statement fraud are aggressiveness, arrogance, cohesiveness, loyalty, blind trust, control ineffectiveness, and gamesmanship.
- Choice. Management is more likely to choose to engage in financial statement fraud when: 1) its personal wealth is closely tied to the company's performance through pay-for-performance plans, 2) management is willing to take personal risks, including the risks of civil or criminal penalties, for corporate benefit, 3) there are opportunities to commit financial statement fraud, 4) there is substantial internal and external pressure to create or maximize shareholder value, and 5) the probability of the fraud being detected is perceived to be very low.
To use the model, auditors can look for "business red flags," (i.e., conditions and circumstances that arise from the perceived need to overcome financial difficulties, such as the inability to meet analysts' forecasts, increased competition, and cash flow shortages), and then advise their clients on steps that can be taken to help eliminate motives and opportunities to engage in fraud.
"The Internal Auditor" is published by The Institute of Internal Auditors.