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Groupthink and financial statement fraud

By Staff

In part two of a four-part series, Toronto forensic accountant and chartered business valuator Patricia Harris explores groupthink in the context of financial statement fraud.

The nature of corporate finance allows groupthink to take hold within businesses, says Toronto forensic accountant and chartered business valuator Patricia Harris.

Although financial statements pass through a number of internal and external layers of review, Harris, a partner with Fuller Landau LLP, tells that group pressures can still lead to the deterioration of mental efficiency, reality testing, and moral judgment throughout this broader group.

“Whether or not you have an explicit conspiracy to misrepresent the company’s financial position, a passive conspiracy, encouraged by groupthink, is necessary for the fraud to occur,” Harris explains. “As professional accountants, we need to better understand how the corporate culture and groupthink mindset may enable financial statement fraud to occur.”

In Harris’s view, the inner core of the group is made up of the accounting and finance managers who generate the reports themselves, but surrounded by an outer core of senior management, including the chief executive and chief financial officers, where financial statement fraud often originates.

Internal oversight by a company’s own audit committee and external oversight by third parties can also be rendered ineffective by groupthink, she says.

“There doesn’t have to be an active conspiracy on behalf of each member of the broad group, but there must at least be a passive conspiracy at play,” Harris adds.

She says companies involved in financial statement fraud often exhibit many of the precursors of groupthink, which include group cohesiveness and impartial leadership.

“There is always time pressure, and you have people working towards a common goal,” Harris says. “When there’s a real motivation to hit certain numbers in a given quarter, people can lose sight of everything else.”

Once a leader, such as the CEO or CFO, gets behind the idea, it can be hard for anyone below them to subsequently speak up or offer evidence that challenges the emerging consensus, she adds.

“The big precursor for me is that people are afraid, to speak their mind, to look dumb, to lose their job, or to seem like they don’t have the knowledge needed to belong in the room,” Harris says.

Situational factors, such as recent failures can also lay the groundwork for groupthink in cases of financial statement fraud, Harris says.

“They may be trying to make up for those by presenting a rosy picture and pumping up the numbers because they need some good news,” she says.

Once questionable decisions are made and dissent is quashed, it makes it easier for them to rationalize and defend as fraudulent statements make their way through the various layers of the group, Harris says.

“Each of the inner core, outer core and the internal oversight may isolate themselves from the external oversight, in particular, the external auditors,” who are seen as bad guys holding the business back,” she says. “What that means is that you might hide something from them, as opposed to genuinely listening to what they say as experts.”

Stay tuned for part three in the series where Harris will discuss the implications of groupthink in a criminal fraud trial.

Click here to read part one exploring the basics and origins of groupthink theory.

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