Markopolizing Conversion Fraud: Understanding and Identifying Opportunities for US Financial Reporting Conversion Fraud

INTRODUCTION Harry Markopolos discovered the largest fraud in US history, while working as a derivatives portfolio manager at Rampart Investment Management. His co-worker and marketing representative, Frank Casey, asked him to analyze Bernie Madoffs "investment" plan in hopes of creating a similar financial product that would rival the stunning moneymaker. Upon review, Markopolos came to the conclusion that Madoffs plan was in fact a fraud and reported his findings to the SEC, but his warning fell upon deaf ears. For almost ten years, he resubmitted warnings to the SEC, but to no avail (Markopolos, 2010). The result of his ordeal uncovered extreme negligence by the US Securities and Exchange Commission (SEC), all while under fear of duress for nearly a decade. The SEC repeatedly refused to thoroughly investigate Bernie Madoff, the former NASDAQ chairman, but Markopolos continued sounding the alarm. The United States is now embarking on a potential fraud explosion: the conversion from the US standard of General Accepted Accounting Principles (GAAP) to the universal standard of International Financial Reporting Standards (IFRS). The former has more stringent accounting practices that the latter; GAAP are rules-and principles-based with a compliance-based focus, while IFRS is purely principles-based, which allows for managerial discretion, and has an economic-based focus (Cancino, 2010, p. 34). To mitigate the risk of fraudulent activities--such as accounting manipulation and earnings management-originating from this conversion, a greater understanding is needed in order to identify such practices when they are present, and create processes that will deter such fraudulent behavior from beginning in the first place. In the spirit of fraud-fighter extraordinaire Harry Markopolos, we must "Markopolize," potential GAAP/IFRS conversion fraud. This term can be defined as: Markopolize: (v) to identify with gusto; to identify with single-minded determination; calling for justice with wanton abandon for self; doing what's right/ethical in face of adversity. In order to carry this out effectively, our understanding of GAAP and IFRS must be strengthened. PURPOSE OF REGULATION AND ESTABLISHMENT OF GAAP Regulation of financial records has developed in the United States since the end of the 19th century. Leuz (2010) determines that there are four core reasons for regulation, "the existence of externalities, market-wide cost savings from regulation, insufficient private (or stricter public) sanctions, and dead-weight costs from fraud and agency conflicts that could be mitigated by disclosure" (p. 231). The origin of regulation in the United States reflects Leuz's rationale. The industrial revolution of the late 19th century spawned a need for common accounting principles which was addressed when the Joint Stock Companies Act of 1884 required an audited balance sheet from firms incorporated under the act. With the stock crash of 1929, "There was a growing realization that a company's stock price was a function of its earnings potential rather than the value of its assets. Hence, the concept of matching revenues and costs became the accountant's primary task and focus" (Close, 2007, p. 38). Following the crash, the Securities and Exchange Commission (SEC) was established by the Securities Act of 1933 and the Securities Exchange Act of 1934. The SEC drew on private organizations for the establishment of accounting standards, namely the American Institute of Accountants, predecessor of the American Institute of Certified Public Accountants. In 1973, the Federal Accounting Standards Board (FASB) became the designated accounting standard setter in the United States, developing the Generally Accepted Accounting Principles (GAAP) that comprise the accounting standards practiced in the US today (SEC, 2012b). CALL FOR INTERNATIONAL STANDARD As the US developed GAAP, many countries also developed their own local standards. …