A.B.C.'s of Behavioral Forensics

Applying Psychology to Financial Fraud Prevention and Detection

Sridhar Ramamoorti, David E. Morrison, III, Joseph W. Koletar, Kelly R. Pope

• Publisher: Wiley
• Year: 2013
• Print ISBN: 9781118370551
• eBook ISBN: 9781118417249
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Contabilidad gerencial

Get practical insights on the psychology of white-collar criminals—and how to outsmart them

Understand how the psychologies of fraudsters and their victims interact as well as what makes auditors/investigators/regulators let down their guard. Learn about the psychology of fraud victims, including boards of directors and senior management, and what makes them want to believe fraudsters, and therefore making them particularly vulnerable to deception. Just as IT experts gave us computer forensics, we now have a uniquely qualified team immersed in psychology, sociology, psychiatry as well as accounting and auditing, introducing the emerging field of behavioral forensics to address the phenomenon of fraud.

Ever wonder what makes a white-collar criminal tick? Why does she or he do what they do? For the first time ever, see the mind of the fraudster laid bare, including their sometimes twisted rationalizations; think like a crook to catch a crook! The A.B.C.'s of Behavioral Forensics takes you there, with expert advice from a diverse but highly specialized authoring team of professionals (three out of the four are Certified Fraud Examiners): a former accounting firm partner who has a PhD in psychology, a former FBI special agent who has been with investigative practices of two of the Big Four firms, an industrial psychiatrist who has worked closely with the C-level suite of large and small companies, and an accounting professor who has interviewed numerous convicted felons. Along with a fascinating exploration of what makes people fall for the common and not-so-common swindles, the book provides a sweeping characterization of the ecology of fraud using The A.B.C.'s of Behavioral Forensics paradigm: the bad Apple (rogue executive), the bad Bushel (groups that collude and behave like gangs), and the bad Crop (representing organization-wide or even societally-sanctioned cultures that are toxic and corrosive). The book will make you take a longer look when hiring new employees and offers a deeper more complex understanding of what happens in organizations and in their people. The A.B.C. model will also help those inside and outside organizations inoculate against fraud and make you reflect on instilling the core values of your organization among your people and create a culture of excellence and integrity that acts as a prophylactic against fraud. Ultimately, you will discover that, used wisely, behavioral methods trump solely economic incentives. With business fraud on the rise globally, The A.B.C.'s of Behavioral Forensics is the must-have book for investigators, auditors, the C-suite and risk management professionals, the boards of directors, regulators, and HR professionals.

• Examines the psychology of fraud in a practical way, relating it to aspects of fraud prevention, deterrence, detection, and remediation
• Helps you understand that trust violation—the essence of fraud—is a betrayal of behavioral assumptions about "trusted" people
• Explains how good people go bad and how otherwise honest people cross the line
• Underscores the importance of creating a culture of excellence and integrity that inoculates an organization from fraud risk (i.e., honest behavior pays, while dishonesty is frowned upon)
• Provides key takeaways on what to look for when hiring new employees and in your current employees, as well as creating and maintaining a culture of control consciousness
• Includes narrative accounts of interviews with convicted white-collar criminals, as well as interpretive insights and analysis of their rationalizations
• Furnishes ideas about how to enhance professional skepticism, how to resist fraudsters, how to see through their schemes, how to infuse internal controls with the people/behavioral element, and make them more effective in addressing behavioral/integrity risks
• Provides a solid foundation for training programs across the fraud risk management life cycle all the way from the discovery of fraud to its investigation as well as remediation (so the same fraud doesn't happen again)
• Enables auditors/investigators to engage in self-reflection and avoid cognitive and emotional biases and traps that lead to professional judgment errors (e.g., overconfidence, confirmation, self-deception, groupthink, halo effect, availability, speed-accuracy trade-off, etc.)

Ever since the accounting scandals surrounding Enron and WorldCom surfaced, leading to the passage of the Sarbanes Oxley Act of 2002, as well as the continuing fall out from the Wall Street financial crisis precipitating the Dodd-Frank Act of 2010, fraud has been a leading concern for executives globally. If you thought you knew everything there was to know about financial fraud, think again. Get the real scoop with The A.B.C.'s of Behavioral Forensics.

PART I

WHEN FRAUD IS COMMITTED

Reading the headlines about another fraudulent scam is upsetting on many levels. When the story is one in which the money stolen is in the billions—and thus beyond conceptualization for the average person, who never crosses paths with such large sums—the media accounts stoke rage and provoke calls for justice.

In the allied professions of management and accounting, similar feelings are aroused. Such outrage is more complex in reality and includes feelings of betrayal by peers, colleagues, or even management or capitalist heroes. Legislatures are called upon, grand speeches are delivered, and references are made to times when people were honest, a man earned a living with his hands, and communities (and markets) were based on trust.

In the end, the widespread loss of trust, personal and corporate reputations, and market confidence is the greatest casualty of a catastrophic fraud.

As more and more resources are put into addressing the problem of fraud, sometimes it just looks as though too little is being done too late, and at other times the efforts don't seem to make a dent at all. The fraud problem simply seems to be increasing in scope and frequency, and newspaper headlines continue to highlight how the last major financial loss has just been surpassed by the most recent.

Consider this curious case of theft. A man named Arthur “the Brain” Rachel gained notoriety for stealing the 45-carat Marlborough diamond from a London jewelry store three decades ago. He was sentenced in 2012 to eight and a half years in prison for racketeering. He had already served many years in jail for other crimes, and he was 73 years old when he received this sentence. When the judge announced the sentence, he asked Rachel why he continued to commit crimes after so many years in prison. Rachel reportedly replied that he and his comrades were bored and had nothing better to do.1

Fraud is theft, and it is often explained in the media as being motivated by greed. For instance, Pedro Espada Jr., a former New York State senator recently convicted of tax evasion and stealing from a health care network he founded, truly had a “rags-to-ill-gotten-riches” story. He survived homelessness in his youth to rise to the highest echelons of state government and brazenly abused his position, perhaps motivated by greed. Before he was indicted, Espada remarked, “There's no way there's a chapter in this story that includes me going to jail. . . . It's surreal. Not a part of my plan or my script.” Commenting on his grandiose sense of entitlement, Eastern District of New York U.S. attorney Loretta E. Lynch called him a “thief in a suit.” She concluded, “Pedro Espada Jr. could have chosen the high road. Every time he had a choice, Pedro Espada chose himself.”2

In contrast, as noted earlier, Arthur Rachel stole items of immense value, but he was not motivated by greed. In both of these cases, might criminal investigations and psychology shine a new and more brilliant light on fraud motivations to broaden and deepen our understanding?3

Beyond the solutions currently applied, new ones are needed. With personal computers becoming popular in the 1980s, computer crime (including hacking) also flourished. This naturally led to the new field of computer forensics viz., forensic methods of examining digital media for identifying, preserving, recovering, analyzing, and presenting facts and opinions, which collectively constitute electronic evidence. Financial forensics has made impressive gains and is also rapidly evolving as a specialized discipline. Financial forensics refers to the plethora of tools, techniques, methods, and methodologies—with a primary focus on analysis and surgically precise dissection of numbers and scenarios—applicable to virtually any large or small economic or financial matter, whether civil, criminal, or involving dispute.4 With the rising incidence of fraud and the realization that fraud is committed by sentient human beings, there is an urgent need for the field of behavioral forensics to exploit the insights of the behavioral disciplines to understand, address, and respond to fraud and perhaps even preempt it.

To understand how fraud happens, new thinking is required to answer this simple question: Why do people commit fraud?

Notes

1. “Jail for Chicago's ‘Brain' in Racketeering Case,” Wall Street Journal, June 8, 2012.

2. Mosi Secret, “Ex-Legislator Guilty of Theft Gets 5-Year Prison Sentence,” New York Times, June 15, 2013.

3. For instance, psychologist Michael Apter argues that it is to keep boredom at bay that youths in wolf packs engage in the practice of “wilding”—an expression that seems to mean “being wild for its own sake,” or being violent. He proceeds to ask, “But how is it that hurting others can produce thrills?” See Michael J. Apter, Danger: Our Quest for Excitement (Oxford, UK: One World Publications, 2007), 6. We will discuss some of Apter's theories later in this book.

4. D. D. Dorrell and G. A. Gadawski, Financial Forensics Body of Knowledge (Hoboken, NJ: John Wiley & Sons, 2012).

CHAPTER 1

Fraud Is Everywhere

Fraud is an interesting concept, because it is both so common and so serious. Fraud is generally everywhere around us; most people do something fraudulent, unwittingly or not, in their lifetimes.

Even such an innocuous thing as two employees chatting for a few minutes in the workplace about last night's baseball game can be a minor form of fraud. After all, they are on company property and are being paid to do other things. Assuming that they are being paid for their time, and that biological needs as well as needs for breaks are provided—many professional service firms bill by the hour—they are defrauding their employer if they are aware that they should be working rather than talking.1

This example may be considered a small infraction, and few people would think of it as fraud, but it could become so, depending on the degree. Association of Certified Fraud Examiners (ACFE) founder and chairman Joseph Wells wrote in the prologue to his autobiography, “Everyone [has lied]. Everyone. We do so for two basic reasons: either to receive rewards or to avoid punishment (or a combination of both). Although lying is not endemic to the human species, we learn it very early in life. Fraud, though, is a lie with a special twist—it is committed to deprive an innocent victim of money or property.”2

Of course, in cases of revenge fraud, the victim may not be so innocent after all.

The Pervasiveness of Fraud

If you ask a room full of midcareer professionals whether they have committed a crime in the past week, almost no one will respond (and perhaps understandably so). Some will be offended by the very nature of the question. But if you then ask them whether they drove just one mile over the speed limit in the past week, they will become sheepish.

“Of course,” they will reply, “but it was only a couple of miles an hour. The cops don't care.” That may be true, but legally speaking, it is a violation of well-understood traffic laws—and therefore a crime. In most cases it may be unintentional (speedometers tend to be subject to margins of error), but in cases of reckless driving, intentional violation of traffic laws unambiguously makes it a crime.

Tom Tyler, Macklin Fleming Professor of law and a professor of psychology at Yale Law School, provides two useful perspectives on legal compliance. The first is the instrumental perspective, wherein he argues that people who take this view obey the law because they fear punishment. The second is the normative perspective, wherein people who believe in social norms and perceptions around equity and fairness feel morally obliged to comply with the law, regardless of the fear of punishment.3 Authorities prefer that citizens hold the normative perspective because it removes the need for law enforcement. Nevertheless, it must be pointed out that people espousing the normative perspective may still decide not to pay their taxes if they believe the tax authorities are unjust. As for those holding the instrumental perspective, their decision primarily relies on weighing the pros and cons of compliance with the law. Stricter enforcement is the only way to dissuade such people from breaking the law.

Fraud, in various small ways, is so common we cease to recognize it. It is just the way people are. It is the normal course of human behavior. Distinguished behavioral economist Dan Ariely makes compelling arguments to provide answers to the following unsettled questions:

• Does the chance of getting caught affect how likely we are to cheat?
• How do companies pave the way for dishonesty?
• Does collaboration make us more honest or less so?4

More than three decades ago, sociologists Edwin H. Sutherland and Donald Ray Cressey offered the “differential association principle” as an explanation for why people act this way. They argued that “people violate the law because the world, the nation, and even the family have multiple moralities.” Consequently, subjectivity and contextual interpretation make “learning to behave in terms of a morality which could land you in jail . . . as easy as learning how to drive your car faster than 55 miles an hour.”5 They concluded that we can only persuade people to follow the right course of action especially true for those people who adopt the instrumental perspective when deciding whether to obey the law.

David Saunders of the Behavioral Sciences Department of Mathtech, a strategy and consulting services firm, asserted that management fraud can be thought of as a “perversion of effective management behavior”—of executives turning to the dark side. He persuasively described the resulting scenario as follows:

Nobody would deny that our system of economic incentives rewards imagination applied in the pursuit of profit, and that it rewards managers who exploit profit opportunities. Nobody would deny that this should be so. Yet this often has the effect of encouraging managers to operate as closely as possible to the borderline between legality and illegality—the borderline between what is ethical and what is unethical. And it follows, in turn, that for any of a variety of reasons, an individual manager or management group may cross over the line [emphasis added].6

Former Securities and Exchange Commission (SEC) chairman Arthur Levitt echoed these ideas in a 1998 speech titled “Numbers Game” delivered at New York University:

[Too] many corporate managers, auditors, and analysts are participants in a game of nods and winks. . . . Managing may be giving way to manipulation; integrity may be losing out to illusion . . . how difficult it is to hold the line on good practices when their competitors operate in the gray area between legitimacy and outright fraud. A gray area where the accounting is being perverted; where managers are cutting corners; and where earnings reports reflect the desires of management rather than the underlying financial performance of the company.7

On Making (Up) the Numbers

Many human beings use cosmetics to enhance their appearance—the color of their lips, skin, or hair—or to improve the way they smell. Cosmetics are also called makeup. To make up is to pretend, to create a false impression—to create a new reality, much as a child may create an invisible friend in the course of play. Misleading others by creating a false impression is called apple polishing for a fruit seller, puffery in advertising, and window dressing when used in financial statements that portray a rosier picture of the financial position than is warranted. A...

Table of contents

• Cover
• Praise
• Title Page
• Copyright
• Dedication
• Epigraph
• Foreword
• Preface: A Serendipitous Journey to This Book
• Acknowledgments
• Introduction
• Part I: When Fraud Is Committed
• Part II: The Foundations of Behavioral Forensics: Why Good People Do Bad Things
• Part III: A Call to Action
• Afterword
• Appendix A: The Psychology and Sociology of Fraud: Integrating the Behavioral Sciences Component into Fraud and Forensic Accounting Curricula
• Appendix B: Chapter Supplements
• Bibliography
• About the Author
• Index