Mitigating Fraud Risk: A
Behavioral Approach
Background for “Now you see it now you don’t:
a one day training on risk assessment”
Cynthia Harrington & Associates LLC
Brain based coaching. Applying behavioral finance.
©2013 Cynthia Harrington & Associates LLC
All rights reserved
Professional Skepticism
• Hone Vision for Red Flags
and Problem Personalities
• Accept the Positive with Eyes
Open
• Study Human Behavioral
Biases
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
My Backgound
• Author: Upcoming Marcum PIF “What's an Honest Hedge Fund Manager to do if ‘Aberrational
Performance’ is to be Investigated, not Celebrated?”
• Designations: Chartered Financial Analyst (CFA) and Certified Fraud Examiner (CFE)
• Founder : Behavioral finance consulting firm Cynthia Harrington & Associates LLC
• Asset Manager: SEC registered adviser 1993-1999 Harrington Capital Management Ltd.
• Financial Adviser: NYSE Registered Rep 1980 – 1993, Piper Jaffray, Bear Stearns
• Author: “Financial Statement Fraud” for ACFE, post-SOX update
• Award winning: “The Value Proposition of Sarbanes-Oxley” editor commendation for Journal of
Accountancy
• Editor: Contributing Editor, Accounting Today 2004-2006
• Expert Writer: 450 articles published for professional audience, CFA Magazine, Journal of
Accountancy, Financial Engineering News, Fraud Magazine
• Speaker : “Five Reasons Why We (Usually) Miss Fraud Signals”, CFA San Francisco, The Atlanta
Group, SE Hedge Fund Association, Mid South Hedge Fund Association, Finance for Future UT
Chattanooga Behavioral Finance Symposium
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Finding the Truth
•
Misstatements arising from fraudulent financial reporting and
•
Misstatements arising from misappropriation of assets
SAS No. 22
SAS No. 1
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SAS No. 47
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SAS No. 85
SAS No. 56
SAS No. 31
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SAS No. 39
SAS No. 67
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SAS No. 56
IAS 39
FAS 133
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
3 Stages to Capitalize
on Knowledge:
Analyze
Check
Sense
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Why It’s So Hard to See
1) Infrequent Occurrence:
Fraud and Criminal
Encounters
2) Industry Positivity Bias
3) Human Biases that Make
Us Easier to Exploit
• Mental shortcuts used to
solve problems and make
judgments without constantly
stopping to think
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Infrequent Occurrence of Fraud
95% of Transactions -- Honest
• Estimated 5% of revenue of typical organization
lost to fraud
• While that’s global fraud loss of more than $2.9
trillion, it is way smaller than gains
Source: ACFE: 2010 Report to the Nations
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Infrequent Occurrence of
Problem Personalities
• 5.9% High Psychopathology Scores
• Versus 1.2% in community at large
“Corporate Psychopathy: Talking the Walk”, Paul Babiak, Ph.D., Craig S. Neumann, Ph.D.,
and Robert D. Hare, Ph.D., Behavioral Sciences and the Law
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Seeing Past the
Positive – Red Flags
#1 Red Flag Financial Statement Fraud -- Slowing Growth
Then:
•
•
•
•
•
Style drift
Unusual relationships
Sudden staff turnover in operations
High percent of hard to value securities
Individual’s lifestyle changes not commensurate with
compensation
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Seeing Past the Positive -Personal Signs of Deception
1. Lack of self-reference
2. Verb tense
3. Answering questions
with questions
4. Equivocation
5. Oaths
6. Euphemisms
7. Alluding to actions
8. Lack of Detail
9. Narrative balance
10. Mean Length of
Utterance
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Human Biases:
Restraint
Overestimation
of
the ability to restrain from
temptation
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Restraint Bias
We overestimate
restraint more
when full than
when hungry
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Human Biases:
Familiarity
Being biased to view more familiar
events (and their complements) as
more likely to occur
than less familiar events (and their
complements)
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Familiarity Bias
The Typical Fraud Perpetrator Is:
• Male;
• 36-45 years old;
• Holds a position in the finance (or a closely related)
department;
• Is in senior management;
• Has been working for the same company for more than
ten years; and
• Operates in collaboration with other offenders.
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Human Biases:
Herding…
When we neglect our private information to
follow the behaviour of the others
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Herding Continued…
In 2010 25% of larger hedge funds were in Apple stock…
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Human Biases:
Confirmation
When we actively seek and assign more weight to
evidence that confirms our hypothesis
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Confirmation Bias…
Will Amazon's Tablet Overtake iPad?”
"Apple Fails Greenpeace “Dirty Data”
Report"
OR
"iPad sales hit 3 million; good news..“
"Why Apple is Dominating the Premium
Computer Market"
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Honing the Vision:
Distinction between…
Fraudulent Behaviors
• Can happen from anyone
• When motivation,
opportunity, and ability to
rationalize are present
Fraudulent Personalities
• People with consistent
patterns of psychopathic
and the sociopathic
behaviors
• Unsuccessful ones in jail
successful ones among
us
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Two Paths
Honest but
pressured, takes
available
opportunity,
rationalizes actions
Calculated and
remorseless
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Patterns of Personality Disorder:
More of the Indicators and More Often
• Difficulty in shifting a
dominant behavior when
situation changes
• Reduced startle reflex
when threat is present
• Dysfunctional response to
another’s sadness or fear
• Don’t learn from mistakes
• Deficient processing of
fearful expressions
• Difficulties with working
memory
• Don’t learn from
supervision
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Review of Common Controls
• Monitor -- trades in accordance with the fund’s investment strategy as documented in
offering memorandums and operating agreements
• Document -- valuation techniques and inputs to valuation for all hard to value and illiquid
securities for each reporting period
• Work with -- an independent committee or board to review and sign off on these
valuations
• Review -- third party relationships for conflicts of interests
• Require -- mandatory vacations and have other employees perform the responsibilities
• Require -- supporting documentation for approval of all fund disbursements
• Safeguard -- assets by segregating the following three responsibilities: 1) check signing/
wire transfer authorization; 2) bank/broker reconciliation; and 3) maintenance of the
books and records (general ledger)
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
3 Stages to Capitalize on
Knowledge – Training in:
Red Flags
Ratio
• 10 signs that
fraud could be
occurring
• 10 ratios that
raise red flags of
financial
statement fraud
Indepth
analysis
including
behavioral
analysis
• 5 biases that keep
us in the dark
• The psychopathic
personality
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Conclusion
• Fraud Probability Rises With Increased Red
Flags
• Biased Thinking Decreases a Person’s Ability to
Recognize Red Flags
• Problem Personalities Differ From Good People
who just have Motivation, Opportunity and
Justification
<Introduction> <Red Flags> <Behavioral Biases> <Problem Personalities>
<Conclusion>
Likeness to truth is not the same as truth.
Peter Bernstein Against the Gods
Thank you!!
Cynthia Harrington & Associates LLC
10940 Wilshire Boulevard Suite 1600
Los Angeles, CA 90024
310-443-4266
cynthia@chcoach.com
www.chcoach.com