CEOs, CFOs, and Accounting Fraud

Article excerpt

Implications of Recent Research

Accounting fraud, or fraudulent financial repotting, has been an ongoing concern for U.S. investors for several decades, with periodic waves of accounting fraud cases leading to substantial investor losses and overall reductions in investor confidence. Research has documented the devastating effects of accounting fraud cases. For example, Jonathan M. Karpoff, D. Scott Lee, and Gerald Martin ("The Cost to Firms of Cooking the Books," Journal of Financial and Quantitative Analysis, 2008) found that firms committing fraud are severely punished by the market: "For each dollar that a firm misleadingly inflates its market value, on average, it loses this dollar when its misconduct is revealed, plus an additional $3.08." In addition, a recent Committee of Sponsoring Organizations of the Treadway Commission (COSO)-sponsored study, "Fraudulent Financial Reporting: 1998-2007," found that fraud firms were much more likely than similar no-fraud firms to declare bankruptcy, be involuntarily delisted, or have material asset sales in the wake of the fraud. Thus, the consequences to investors of accounting fraud often are quite severe.

Recent research provides important new insights into the role of CEOs and CFOs in accounting fraud. In this article, the authors discuss these findings and offer a number of implications for directors, audit committee members, and auditors seeking to prevent or detect accounting fraud. The authors conclude by highlighting some useful antifraud resources.

Recent Research Findings

The Exhibit presents information on six recent studies mat examined issues related to CEOs, CFOs, and accounting fraud. The first two studies documented that accounting fraud is largely driven by the CEO and CFO (top management). The first study, 'Fraudulent Financial Reporting: 1998-2007," examined 347 alleged accounting fraud cases investigated by the SEC. The study revealed that financial statement fraud cases often involve the top executives, with the CEO or CFO implicated in 89% of the cases. CEOs were implicated in 72% of the cases, and CFOs in 65%. While lower level personnel often are coerced into carrying out the mechanics of the fraud scheme, the percentages for CEO and CFO involvement are far higher than for any other type of employee in the company (all less than 40%). In a prior COSO-sponsored study, "Fraudulent Fuiancial Reporting: 1987-1997," the CEO or CFO were named in 83% of the cases; therefore, CEO/CFO involvement continues to be found in the vast majority of fraudulent financial reporting cases, and this appears to be increasing. Given the significant expenditures of time and money devoted to reducing fraud in recent years, such results suggest that fraud prevention and detection efforts may be performed in a more effective and efficient manner with a more targeted focus on the CEO/CFO.

The second study, "Report to the Nations: 2010 Global Fraud Study," was based on a global survey administered by the Association of Certified Fraud Examiners (ACFE) and found a similar result The study analyzed more than 1,800 fraud cases (primarily occupational fraud) that were investigated by certified fraud examiners. Nearly 14% of the frauds involving executives or upper management were fraudulent financial reporting cases, while less than 5% of the total cases involved fraudulent financial reporting. Thus, fraudulent financial reporting cases were concentrated among executive and upper-management perpetrators.

Based on these two studies, it is clear mat accounting fraud typically involves CEOs and CFOs, who may coerce lower level employees to participate as well. What is not clear, however, is why some CEOs and CFOs participate in accounting fraud. The third study, by Mei Feng, Weili Ge, Shuqing Luo, and Terry Shevlin, offers new insights into this issue ("Why Do CFOs Become Involved in Material Accounting Manipulations?" Journal of Accounting and Economics, 2011). …