Chapter 5. Fraud, Negligence, and Entropy: What Can Go Wrong and How to Prevent It

Complying with regulations such as Sarbanes-Oxley (SOX) now means that companies and their senior executives have to get clean: certify that their financial reports are accurate, abide by a stated code of ethics, disclose changes to their material information, and refrain from shredding documents. Regulations also mean companies have to stay clean, and this process is called governance.

This chapter addresses how things got messy in the first place. We look at what the errors are — intentional or otherwise — that companies make on a day-to-day basis that open them up to fraud and bad governance.

In the U.S., the SEC prosecutes three levels of culpability: negligence, gross negligence, and fraud. In this chapter, we address these, as well as another quality that makes for financial unkemptness: entropy. Entropy means that things fall apart, not intentionally, but through bad management and bad systems.

The good news is that SOX's rigorous financial reporting requirements have led to fewer prosecutions for fraud and negligence. Research from Deloitte shows that the number of fraud actions has fallen since 2003, when SOX became law. Companies are getting clean and staying clean.

Defining Fraud

Fraud is a deliberate misrepresentation of events that causes another person to suffer damages, usually monetary ones. Fraud — or the opportunity to be fraudulent — is all around us. We are faced with the opportunity ...

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