The Auditors Report

Fraudulent Financial Reporting:
1987–1997
An Analysis of U.S. Public Companies

Research Commissioned by COSO, the Committee of Sponsoring Organizations
of the Treadway Commission, Copyright COSO, 1999

Mark S. Beasley, North Carolina State University, Joseph V. Carcello, University of Tennessee, Dana R. Hermanson, Corporate Governance Center, Kennesaw State University

Executive Summary
The Committee of Sponsoring Organizations of the Treadway Commission (COSO) sponsored this research project to provide an extensive updated analysis of financial statement fraud occurrences. This research has three specific objectives:

  • To identify instances of alleged fraudulent financial reporting by registrants of the U.S. Securities and Exchange Commission (SEC) first described by the SEC in an Accounting and Auditing Enforcement Release (AAER) issued during the period 1987–1997.
  • To examine certain key company and management characteristics for a sample of these companies involved in instances of financial statement fraud.
  • To provide a basis for recommendations to improve the corporate financial reporting environment in the U.S.

We analyzed instances of fraudulent financial reporting alleged by the SEC in AAERs issued during the 11-year period between January 1987 and December 1997. We focused on AAERs that involved an alleged violation of Rule 10(b)-5 of the 1934 Securities Exchange Act or Section 17(a) of the 1933 Securities Act given that these represent the primary antifraud provisions related to financial statement reporting. Our search identified nearly 300 companies involved in alleged instances of fraudulent financial reporting during the 11-year period. From this list of companies, we randomly selected approximately 200 companies to serve as the final sample that we examined in detail.

Summary of Findings

Nature of Companies Involved

  • Relative to public registrants, companies committing financial statement fraud were relatively small. The typical size of most of the sample companies ranged well below $100 million in total assets in the year preceding the fraud period. Most companies (78 percent of the sample) were not listed on the New York or American Stock Exchanges.

Nature of the Control Environment (Top Management and the Board)

  • Top senior executives were frequently involved. In 72 percent of the cases, the AAERs named the chief executive officer (CEO), and in 43 percent the chief financial officer (CFO) was associated with the financial statement fraud. When considered together, in 83 percent of the cases, the AAERs named either or both the CEO and CFO as being associated with the financial statement fraud.
  • Most audit committees only met about once a year or the company had no audit committee. Audit committees of the fraud companies generally met only once per year. Twenty-five percent of the companies did not have an audit committee. Most audit committee members (65 percent) did not appear to be certified in accounting or have current or prior work experience in key accounting or finance positions.
  • Boards of directors were dominated by insiders and “gray” directors with significant equity ownership and apparently little experience serving as directors of other companies. Approximately 60 percent of the directors were insiders or “gray” directors (i.e., outsiders with special ties to the company or management). Collectively, the directors and officers owned nearly one-third of the companies’ stock, with the CEO/President personally owning about 17 percent. Nearly 40 percent of the boards had not one director who served as an outside or gray director on another company’s board.
  • Family relationships among directors and/or officers were fairly common, as were individuals who apparently had significant power. In nearly 40 percent of the companies, the proxy provided evidence of family relationships among the directors and/or officers. The founder and current CEO were the same person or the original CEO/President was still in place in nearly half of the companies.

Nature of the Frauds

  • Cumulative amounts of frauds were relatively large in light of the relatively small sizes of the companies involved. The average financial statement misstatement or misappropriation of assets was $25 million and the median was $4.1 million. While the average company had assets totaling $533 million, the median company had total assets of only $16 million.
  • Most frauds were not isolated to a single fiscal period. Most frauds overlapped at least two fiscal periods, frequently involving both quarterly and annual financial statements.
  • Typical financial statement fraud techniques involved the overstatement of revenues and assets. Over half the frauds involved overstating revenues by recording revenues prematurely or fictitiously. Many of those revenue frauds only affected transactions recorded right at period end (i.e., quarter end or year end). About half the frauds also involved overstating assets by understating allowances for receivables, overstating the value of inventory, property, plant and equipment and other tangible assets, and recording assets that did not exist.

Issues Related to the External Auditor

  • All sizes of audit firms were associated with companies committing financial statement frauds. Fifty-six percent of the sample fraud companies were audited by a Big 8/6 auditor during the fraud period, and 44 percent were audited by non-Big 8/6 auditors.
  • All types of audit reports were issued during the fraud period. A majority of the audit reports (55 percent) issued in the last year of the fraud period contained unqualified opinions. The remaining 45 percent of the audit reports issued in the last year of the fraud departed from the standard unqualified auditor’s report. Three percent of the audit reports were qualified due to a GAAP departure during the fraud period.
  • Financial statement fraud occasionally implicated the external auditor. Auditors were explicitly named in the AAERs for 56 of the 195 fraud cases (29 percent) where AAERs explicitly named individuals. They were named for either alleged involvement in the fraud (30 of 56 cases) or for negligent auditing (26 of 56 cases). Most of the auditors explicitly named in an AAER (46 of 56) were non-Big 8/6 auditors.
  • Some companies changed auditors during the fraud period. Just over 25 percent of the companies changed auditors during the time frame beginning with the last clean financial statement period and ending with the last fraud financial statement period. A majority of the auditor changes occurred during the fraud period (e.g., two auditors were associated with the fraud period) and a majority involved changes from one non-Big 8/6 auditor to another non-Big 8/6 auditor.

Consequences for the Companies

  • Severe consequences awaited companies committing fraud. Consequences of financial statement fraud to the company often include bankruptcy, significant changes in ownership and delisting by national exchanges, in addition to financial penalties imposed. A large number of the sample firms (over 50 percent) were bankrupt/defunct or experienced a significant change in ownership following disclosure of the fraud.

Summary of Implications Implications Related to the Nature of the Companies Involved

  • The national stock exchanges and regulators should evaluate the trade-offs of designing policies that might exempt small companies, given the relatively small size of the companies involved in financial statement fraud. A regulatory focus on companies with market capitalization in excess of $200 million may fail to target companies with greater risk for financial statement fraud activities.

Implications Related to the Nature of the Control Environment (Top Management and the Board)

  • The importance of the organization’s control environment cannot be overstated, as emphasized in COSO’s Internal Control– Integrated Framework. Monitoring the pressures faced by senior executives (e.g., pressures from compensation plans, investment community expectations, etc.) is critical.
  • The concentration of fraud among companies with under $50 million in revenues and with generally weak audit committees highlights the importance of rigorous audit committee practices even for smaller organizations. In particular, the number of audit committee meetings per year and the financial expertise of the audit committee members may deserve closer attention.
  • It is important to consider whether smaller companies should focus heavily on director independence and expertise, like large companies are currently being encouraged to do. In the smaller company setting, due to the centralization of power in a few individuals, it may be especially important to have a solid monitoring function performed by the board.
  • Investors should be aware of the possible complications arising from family relationships and from individuals (founders, CEO/board chairs, etc.) who hold significant power.

Implications Related to the Nature of the Frauds

  • The multi-period aspect of financial statement fraud, often beginning with the misstatement of interim financial statements, suggests the importance of interim reviews of quarterly financial statements and the related controls surrounding interim financial statement preparation, as well as the benefits of continuous auditing strategies.
  • The nature of misstatements affecting revenues and assets recorded close to or as of the fiscal period end highlights the importance of effective consideration and testing of internal control related to transaction cut-off and asset valuation. Based on the assessed risk related to internal control, the auditor should evaluate the need for substantive testing procedures to reduce audit risk to an acceptable level and design tests in light of this consideration. Procedures affecting transaction cut-off, transactions terms and account valuation for end-of-period accounts and transactions may be particularly relevant.

Implications Regarding the Roles of External Auditors

  • There is a strong need for the auditor to look beyond the financial statements to understand risks unique to the client’s industry, management’s motivation toward aggressive reporting and client internal control (particularly the tone at the top), among other matters. As auditors approach the audit, information from a variety of sources should be considered to establish an appropriate level of professional skepticism needed for each engagement.
  • The auditor should recognize the potential likelihood for greater audit risk when auditing companies with weak board and audit committee governance.

Conclusion

A copy of the full report can be ordered through the AICPA by calling [888] 777-7077 and requesting item #990036. We hope that this research will be useful to the auditing community.

NOTE: This article is excerpted with permission from Fraudulent Financial Reporting 1987–1997, An Analysis of U.S. Companies, copyright COSO, 1999.

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