Preventing rotten apples
Cause and Effect
Fraudulent financial reporting can have significant consequences for organizations and for public confidence in capital markets. High-profile cases of fraudulent financial reporting raise concerns about the credibility of the U.S. financial reporting process and the roles of auditors, regulators, and analysts in financial reporting.
The results of the author's study show that four characteristics of an organization's culture can predispose a company to consider fraudulent financial reporting as a legitimate accounting policy decision. Companies that issue fraudulent financial statements are more likely to engage in related-party transactions, to have founders that still exert major influence over the company. to employ fewer CPSs, and to exhibit a history of illegal violations.
According to the Treadway Commission Report of 1999, it significant proportion of the companies that committed fraud were owned by their founders and board members. In addition, the Committee of Sponsoring Organizations (COSO) report of 1999, states that in 72, of the fraud cases examined, the CEO appeared to be associated with the fraud and the companies' boards of directors were dominated by insiders and others with significant ties to the company.
Do organizations that issue fraudulent financial statements have a different organizational culture than those that follow GAAP requirements? To answer this question. the author examined 160 companies. half of which had issued fraudulent financial statements in the last few years and half that have not been found guilty of fraudulent reporting (see Exhibit 1).
The results Show that four characteristics of an organization's culture predispose the company to consider fraudulent financial reporting a legitimate accounting policy decision. Firms that issue fraudulent financial statements are more likely to engage in related-party transactions, to have founders that still exert major influence over the company to employ fewer CPAs, and to exhibit a history of illegal violations.
Previous Studies and Analysis
Karl Hackenbrack's 1993 study, "The Effect of Experience with Different-Sized Clients on Auditor Evaluations of Fraudulent Financial Reporting Indicators," stated that no company, regardless of size or business, is immune to fraud. He argued that normal business activities introduce incentives and opportunities that can lead to fraud. The National Association of Corporate Directors' 1998 "Report of the NACD Blue Ribbon (Commission on CEO Succession" concluded that the primary responsibility for the prevention and detection of fraud rests with management, boards of directors, and audit committees. These conclusions indicate that management should create a culture that deters fraud and should set clear corporate policies against improper conduct.
According to SAS 53, The Auditor's Responsibility to Detect and Report Errors and Irregularities, issued in 1988, irregularities include fraudulent financial reporting undertaken to render financial statements misleading, sometimes called management fraud, and misappropriation of assets, sometimes called defalcations. This statement was superseded by SAS 82, Consideration of Fraud in a Financial Statement Audit, issued in 1997, which expanded the responsibility of the auditor to detect errors and irregularities to include fraudulent financial reporting and fraud arising from the misappropriation of assets. SAS 82 explains that even though fraud is a broad legal concept, the auditor's interest specifically relates to fraudulent acts that create a material misstatement in the financial statements. Furthermore, the primary factor that distinguishes fraud from error is whether the misstatement is intentional or unintentional. SAS 82 also explains that two types of misstatements are relevant to an auditor in an audit of financial statements: misstatements arising from fraudulent financial reporting, and misstatements arising from the misappropriation of assets. …