On May 20, 2010, the Committee of Sponsoring Organizations of the Treadway Commission (COSO) released a study, Fraudulent Financial Reporting: 1998-2007: An Analysis of U.S. Public Companies. The study examined nearly 350 financial statement fraud allegations investigated by the SEC over a ten-year period. By examining key company and management characteristics for the companies involved in instances of financial statement fraud, this study provides insights related to preventing, deterring, and detecting fraudulent financial reporting.
Financial fraud affects companies of all sizes, with the median company having assets and revenues just under $100 million. The median fraud was $12.1 million, although more than 30 of the fraud cases each involved misstatements/misappropriations of $500 million or more. Although fraudulent financial reporting can occur in any industry, the study showed that the most frequent industries where fraud occurred included computer hardware and software and other manufacturing, healthcare/health products, retailers/wholesalers, other service providers, and telecommunications. Most of the frauds were committed at or directed from the companies headquarters. The highest percentages of frauds involved companies headquartered in California and New York.
The financial health of some of the companies involved was generally close to a break-even position in the periods before the fraud. This finding warrants enhanced skepticism on the part of board members, auditors, and regulators when companies are experiencing financial stress. This financial stress clearly took its toll on CEOs and CFOs who were named for some level of involvement in nine out of ten cases. The most commonly cited motivations for fraud include the need to:
- Meet external or internal earnings expectations;
- Conceal the company's deteriorating financial condition;
- Increase the stock price;
- Bolster financial performance for pending equity or debt financing; or
- Increase management compensation based on financial results.
Although assets were misappropriated in some of the frauds, the intentional misstatement of financial statements was noted much more frequently and involved improper revenue recognition, asset overstatements, and/or understatement of expenses or liabilities. Improper revenue recognition accounted for more than 60 percent of the cases and transpired through a variety of tactics including recording fictitious or premature revenues through sham sales, conditional sales, round-tripping or recording loans as sales, bill-and-hold transactions, premature revenues before all terms of the sale were complete, improper sales cutoff, improper use of the percentage-of-completion method, unauthorized shipments and consignment sales. Financial statement frauds generally involved multiple fiscal periods. Fraud periods extended on average for 31 months.
Another interesting finding regarding fraudulent financial reporting is that fraud companies disclosed significantly more related-party transactions than non-fraud companies. The higher frequency of related-party transactions for fraud companies may suggest heightened fraud risk and require greater scrutiny of such transactions to determine if the nature of those transactions has broader implications on management’s integrity, philosophy, and ethical culture.
View Fraudulent Financial Reporting: 1998-2007: An Analysis of U.S. Public Companies in full. COSO encourages those involved in financial reporting to carefully consider the results reported in this study and recommit their efforts to improve the prevention, deterrence, and detection of fraudulent financial reporting.
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