COSO's Fraud Study: What It Means for CPAs
The Committee of Sponsoring Organizations of the Treadway Commission (COSO) has just published a follow-up study to its landmark 1987 report. Fraudulent Financial Reporting: 1987-1997, An Analysis of U.S. Public Companies, examines financial reporting fraud cases the SEC has brought against U.S. public companies. Here, the authors of the study share some key findings and add their recommendations. COSO commissioned this study to help in its efforts to combat financial statement fraud and find the answers to these questions: Who is committing fraud? What is the nature? The study examined instances of alleged fraudulent financial reporting by SEC registrants reported in SEC Accounting and Auditing Enforcement Releases (AAERs) in the 11-year period from 1987-1997. The study identified approximately 300 total frauds and specifically covers 200 randomly selected companies involved in financial statement fraud. The study identifies key company and management characteristics that could help auditors identify the warning signs. Who's committing the fraud? Companies committing financial statement fraud were relatively small. The typical company had well below $100 million in total assets in the year preceding the fraud. Most companies--78% in fact--were not listed on the New York or American Stock Exchanges. And as might be expected, some companies committing fraud were experiencing net losses or were barely breaking even in the periods before the fraud. The median net income was only $175,000 in the year before the fraud--financial pressures may have provided incentives for the fraudulent activities of some companies. Senior executives were frequently involved. In 72% of the cases, the AAERs named the CEO; in 43% they named the CFO. As for audit committees, most met about once a year--and 25% of the companies didn't have audit committees at all. Of those that did, more than half the audit committee members (65%) did not appear to be certified in accounting or have current or prior work experience in key accounting or finance positions. The boards of directors in companies with the alleged fraudulent reporting were generally insiders and "gray" directors (outsiders with special ties to the company or management), with significant equity ownership and apparently little experience serving as directors. Collectively, the directors and officers owned nearly 33% of the companies' stock, with the CEO/president personally owning about 17%. In nearly 40% of the boards, no director had served as an outside or gray director on another company's board. In nearly 40% of the companies, the proxy provided evidence of family relationships among the directors or officers. The founder and current CEO were the same person or the original CEO was still in place in nearly half of the companies. In more than 20% of the companies, there was evidence that officers held incompatible job functions, for example, acting as both CEO and CFO. External auditors were also involved. In the 195 fraud cases where AAERs explicitly named individuals, auditors were named in 56 (29%)--either for alleged involvement in the fraud (30 cases) or for negligent auditing (26 cases). And problematic companies jumped around: More than 25% of the companies changed auditors from the last clean financial statement period to the last fraudulent financial statement period. What kind of frauds? Overall, the frauds were relatively large in amount when compared with the small size of the companies involved: The median amount of financial statement misstatement or misappropriation of assets was $4.1 million although the median amount of total company assets was only $16 million. The frauds were not one-shot deals, either: Most frauds overlapped at least two fiscal periods, frequently involving both quarterly and annual financial statements. The average fraud period extended over 23.7 months. Typical financial statement fraud techniques involved the overstatement of revenues and assets (see exhibit 1). …