Description
This paper builds on the Committee of Sponsoring Organizations (COSO) Report, which
examined US Accounting and Auditing Enforcement Releases (AAERs). The purpose of this paper is
to provide valuable insights into the characteristics and realities of financial statement fraud in the
post-Enron regulatory environment.
Accounting Research Journal
The changing face of regulators' investigations into financial statement fraud
Richard Lane Brendan T. O'Connell
Article information:
To cite this document:
Richard Lane Brendan T. O'Connell, (2009),"The changing face of regulators' investigations into financial
statement fraud", Accounting Research J ournal, Vol. 22 Iss 2 pp. 118 - 143
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Rodney L. Crawford, Thomas R. Weirich, (2011),"Fraud guidance for corporate counsel reviewing
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G. Stevenson Smith, (2012),"Can an auditor ever be a first responder to financial frauds?", J ournal of
Financial Crime, Vol. 19 Iss 3 pp. 291-304 http://dx.doi.org/10.1108/13590791211243138
Cenap Ilter, (2014),"Misrepresentation of financial statements: An accounting fraud case from Turkey",
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The changing face of regulators’
investigations into ?nancial
statement fraud
Richard Lane
School of Business, James Cook University, Townsville, Australia, and
Brendan T. O’Connell
School of Accounting and Law, RMIT University, Melbourne, Australia
Abstract
Purpose – This paper builds on the Committee of Sponsoring Organizations (COSO) Report, which
examined US Accounting and Auditing Enforcement Releases (AAERs). The purpose of this paper is
to provide valuable insights into the characteristics and realities of ?nancial statement fraud in the
post-Enron regulatory environment.
Design/methodology/approach – This paper analyses a sample of AAERs from 2002 to 2005.
It also provides case studies of an additional ?ve high-pro?le case studies from that period.
Findings – This paper ?nds evidence of changes in Securities and Exchange Commission (SEC)
enforcement activities since the COSO Report. Speci?cally, it is found that enforcement activities have
increased substantially post-Enron and the companies subject to AAERs are, on average, much larger,
more pro?table and the frauds are more substantial than those exhibited in the COSO Report. These
?ndings suggest that the SEC has become more aggressive at pursuing larger companies for ?nancial
statement fraud in the post-Enron environment.
Research limitations/implications – This paper relies on AAERs as the source of analysis of
?nancial statement fraud, its ?ndings must be viewed in light of the limitations of using these
documents. Speci?cally, the prevailing prosecutions agenda of the US SEC may be re?ected in these
results.
Practical implications – The study ?ndings are of great practical relevance to accounting
regulators and practitioners as they provide valuable insights into the nature and characteristics of
?nancial statement fraud.
Originality/value – The paper provides empirical evidence concerning the changing face of ?nancial
statement fraud enforcement and provides a more in-depth comparison of fraud than possible with most
previous studies that have tended to focus on quantitative measures. This is possible because the
present investigation utilises qualitative data from AAERs to supplement quantitative ?ndings.
Its originality is also due to the use of institutional theorywhichis not commonly appliedinthe corporate
governance ?eld.
Keywords Organizational analysis, Financial reporting, Fraud, United States of America, Accounting,
Auditing
Paper type Research paper
1. Introduction
This analysis of the US Securities and Exchange Commission’s (SEC’s) Accounting
and Auditing Enforcement Releases (AAER’s) seeks to provide valuable insights into
the characteristics and realities of ?nancial statement fraud within US companies
during the period 2002-2005. While the data set for this study is drawn from the USA,
we believe that the ?ndings have strong relevance for all developed capital markets
and their regulators; including Australia. Employing a cross-case analysis of AAERs,
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
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Accounting Research Journal
Vol. 22 No. 2, 2009
pp. 118-143
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309610910987484
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our study documents how senior management of these companies deliberately sought
to hide the realities of their company’s performance from stakeholders often across
many years. In this way, we aim to enhance understanding of key characteristics of
?nancial statement frauds such as their size and the length of their perpetration.
In addition to the above objective, the present investigators also seek to compare our
?ndings with those reported by the Committee of Sponsoring Organizations (COSO) of
the Treadway Commission 1987-1997 (COSO Report, 1999). Speci?cally, we aim to
compare common characteristics of ?nancial statement fraud pre and post issuance of
that report and whether the focus of SEC prosecutions has changed over that period.
The rationale for this comparison is to study whether “high pro?le” accounting
scandals such as Enron and WorldCom have resulted in changes to the foci of
investigations conducted by the SEC and the targets of those investigations.
The present study contributes to the literature in three major ways. First, it provides
empirical evidence concerning the changing face of ?nancial statement fraud
enforcement. Second, it provides a more in-depth comparison of fraud than possible
with most previous studies that have tended to focus on quantitative measures. This is
possible because the present investigation utilises qualitative data from AAERs to
supplement quantitative ?ndings. Third, in using institutional theory it applies a
theoretical framework that is not commonly applied in the corporate governance ?eld
which tends to emphasise agency and transaction cost perspectives (Peasnell et al., 2005;
Lin, 2008).
As noted above, the theoretical basis of our study is drawn from institutional theory.
Institutional theory adopts an open system perspective where organizations are
strongly in?uenced by their environments (DiMaggio and Powell, 1983; Bealing et al.,
1996). We hypothesize that, post-2001, the SEC responded to the voluminous criticismof
regulation of companies emanating fromthe major accounting scandals by signi?cantly
increasing the number and scale of its enforcement activities to ensure maintenance of
its societal legitimacy.
2. Literature review
2.1 COSO Report
In 1999, the COSO of the Treadway Commission released the study, Fraudulent
Financial Reporting: 1987-1997, an analysis of US Public Companies (COSO Report,
1999). The report has since been widely circulated and cited (Wells, 2001; Beasley et al.,
2000). The COSO Report (1999, p. 1) boasted that, “For the ?rst time, we have a clear
understanding of the who, why, where and how of ?nancial reporting fraud”. These
researchers analysed AAERs issued by the SEC over an 11-year period between
January 1987 and December 1997. The subject of their analyses were instances of
alleged violations of Rule 10(b)-5 of the 1934 Securities Exchange Act or Section 17(a)
of the 1933 Securities Act, they being the main anti-fraud provisions that relate to
?nancial statement reporting. A random sample of 220 cases of ?nancial statement
fraud were subjected to analysis, however, the researchers found that only in 99 cases
were they able to obtain the “last clean ?nancial statements” (p. 15).
Major ?ndings of the COSO Report were that the companies involved in ?nancial
statement fraud tended to be relatively small; some companies committing the fraud
were experiencing net losses or were close to break-even prior to the fraud; top senior
executives were frequently involved; cumulative amounts of fraud were relatively
Financial
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large relative to company size and were not isolated to a single period; and, typical
fraud techniques involved overstatement of revenues (COSO Report, 1999, pp. 5-6).
2.2 Incentives to manipulate accounting earnings
The ?ndings of the COSO Report should also be considered in light of a number of
studies that have examined the incentives for ?nancial statement fraud and/or earnings
management (Dechow et al., 1996; Graham et al., 2005). A brief overview follows. There
are several motivations for why managers might manipulate reported earnings to
achieve some aim such as achieving an earnings target, employee bonuses, bond
covenants, stakeholder motivations and stock price motivations. Broadly, the literature
to date has found that companies generally just beat earnings benchmarks such as stock
analysts’ consensus estimates (DeGeorge et al., 1999), the share price tends to react very
adversely to negative earnings surprises (Barth et al., 1999), ?rms can enhance their
reputationwithstakeholders suchas customers by managing earnings (Burgstahler and
Dichev, 1997) and managers exercise accounting discretion to maximise bonuses (Healy,
1985). However, there is no evidence that earnings are managed to reduce the probability
of violating a covenant (Watts and Zimmerman, 1990).
Two studies of particular interest to the present study are Graham et al. (2005) and
Dechowet al. (1996) given that they focussed on the views of ?nancial executives or were
sourced directly from AAERs. Graham et al. (2005) surveyed over 400 US ?nancial
executives and found disturbingly that poorly performing ?rms are likely to take
measures to delay bad news, that reported earnings rather than cash?ows are the major
metric analysed by stakeholders, meeting or exceeding benchmarks is very important to
executives’ credibility, executives prefer smooth rather than volatile earnings, and that
they feel pressure to take decisions that may sacri?ce long-term value to meet earnings
targets. Mechanisms used to meet benchmarks would include a range of accounting
discretionary choice such as changing in accounting assumptions together with
discretionary spending choices such as deferral of investment projects.
Dechow et al. (1996) examined US ?rms subject to AAERs and found that ?rms
manipulating earnings are more likely to: have boards of directors dominated by
management, a chief executive of?cer (CEO) who is also chairman of the board and a
CEO who also happened to found the ?rm. They are less likely to have an audit
committee and an outside blockholder.
2.3 Criticisms of AAERS and the COSO Report
There have been several studies utilising AAERs which have evaluated their
limitations (Feroz et al., 1991; Bonner et al., 1998) and critiques of the COSO Report
(1999) itself (Briloff, 2001; O’Connell, 2001). In terms of the limitations of AAERs
themselves, Feroz et al. (1991) reported that SEC enforcement actions differ in their
nature and severity. Bonner et al. (1998) recognized this problem and attempted to
control for differences in severity by assigning each action a value for severity from the
external auditor’s perspective. Bonner et al. (1998, p. 505) also emphasized the strong
possibility of selection bias emanating from reliance on AAERs. They speci?ed that
these enforcement actions might re?ect speci?c SEC agendas prevailing at the time of
the sample selection. If this is the case, sole reliance on enforcement actions might not
produce a sample of frauds that is truly representative of the entire population of
?nancial statement frauds.
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The SEC (1989, p. 1) admits that its enforcement program is designed to
“concentrate on particular problems areas and to anticipate emerging problems”. As an
example of this SEC agenda bias, Feroz et al. (1991) reported that 70 per cent of all
AAERs issued between 1982 and 1989 related to alleged overstatement of accounts
receivables and inventories by ?rms. Furthermore, Feroz et al. (1991, pp. 111-2)
highlighted that interviews with current and former SEC of?cials show that the SEC
has more targets for formal investigations than it can practically pursue and that they
need to limit their investigations to instances where material violations are alleged to
have occurred. They noted that formal investigations are both costly and highly visible
and this means that the SEC is forced to rank candidates for formal investigation
“according to the probability of success and potential message value” (Feroz et al.,
1991, p. 112).
Turning to evaluation of the COSOReport (1999) itself, perhaps the most high pro?le
of these critiques was Briloff (2001). Key aspects of his criticism were that the selection
process produced a group of companies that were not representative of the high-pro?le
cases that, in his view, were “contaminating the accounting and ?nancial reporting
environment” (p. 126). Briloff was especially critical of the obvious lack of high-pro?le
cases in the sample given the small size of companies re?ected in the demographic data
of the study. Briloff (2001) then produced his own study to support this claim.
He emphasized that the company with the highest total revenue almost equaled the total
revenues of the remaining 98 companies. He concluded that the sampling approach
created a “distorted image of the corporate enterprises in our ?nancial reporting
environment” (p. 126).
O’Connell (2001) supported Briloff’s claim stating that “researchers who have used
AAERs also recognize the limitations of relying on AAERs to evaluate ?nancial
statement fraud” (p. 168). He highlighted that they differ in their nature and severity
and that they are uneven in their level of disclosure. Further, O’Connell (2001) criticized
the absence of details of individual cases in its sample. He stated that “this lack of
?nancial data on sample ?rms is clearly frustrating and a major limitation of the COSO
Report” (p. 171).
O’Connell (2001) also evaluated the sampling approach of the COSO Report (1999).
He noted that one of the major conclusions of the COSO Report (1999, p. 2) is that
“companies committing ?nancial statement fraud were relatively small”. He argued
that this ?nding is only valid if one assumes AAERs are truly representative of all
?nancial statement fraud and if one assumes that the omitted ?rms are similar in
character to those 99 ?rms portrayed in the COSO Report (1999). O’Connell (2001)
observed that if one assumes both of these conditions are met then the population will
be skewed towards smaller ?rms. Moreover, when a population is skewed one way and
a random sample is taken from that population, then the resultant sample is likely to
re?ect that particular distribution shape (in this case, a plethora of small ?rms and not
too many large ones).
O’Connell (2001) concluded that such a sampling outcome is of great concern in this
case as it is the high-pro?le cases of ?nancial statement fraud that make the front
pages of the Wall Street Journal and that if one is concerned about restoring public
faith in the accounting profession, then one must study and enhance understanding of
what drives these high-pro?le cases. To enhance the usefulness of the COSO study, he
advocated a sampling approach that includes large, high-pro?le cases.
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2.4 The SEC and institutional theory
Any study that utilizes AAERs as a primary data source cannot drawconclusions from
themwithout ?rst considering the institutional environment in which these enforcement
releases are issued. Accordingly, we will draw on institutional theory to inform our
analysis.
Institutional theory, according to Scott (1987) and DiMaggio and Powell (1983, p. 53),
proposes that many aspects of formal organizational structures, policies and
procedures result from prevailing societal attitudes and the views of important
constituents. Organizations obey these rules and requirements, not just on ef?ciency
grounds, but also to enhance their legitimacy, resources and survival capacities
(Kondra and Hinings, 1998). Institutional pressures operate in conjunction with other
forces such as competition to effect ecological dynamics. Organizational behaviour is
inextricably ingrained in a vibrant system of interrelated economic, institutional and
ecological in?uences (DiMaggio and Powell, 1983).
Researchers have noted that there are some striking similarities between
institutional theory and so-called “legitimacy theory”. Legitimacy theory assumes
that businesses are bound by the social contract in which they agree to perform various
socially desired actions in return for approval of their objectives and other rewards,
and this ultimately guarantees their continued existence (Guthrie and Parker, 1989).
This de?nition has clear similarities with what we have already stated about
institutional theory. Deegan (2002, p. 293), when describing institutional theory, noted:
Re?ecting the overlapping nature of many theories, the notion of legitimacy is also central to
institutional theory [. . .] Under this [latter] theory, organisations will change their structure or
operations to conform with external expectations about what forms or structures are
acceptable (legitimate).
Deegan (2002, p. 294) makes the following further observation:
However, in contrast to legitimacy theory, wherein there is perceived to be an ability of
managers to alter perceptions of legitimacy (perhaps through disclosures), under institutional
theory managers are expected to conform with norms that are largely imposed upon them.
Of relevance to the present study, Bealing et al. (1996) utilised institutional theory to
examine the historical development of the SEC and, in particular, the form, content and
rhetoric of its early regulatory actions as a case example of an organization attempting
to justify its existence and role in the ?nancial markets. They found:
[. . .] that in order for the SEC as an organization to become legitimated [. . .] as part of the
regulatory arena, it had to take part in building up [. . .] a framework of social control applied
to the accounting profession as well as reporting entities (p. 335).
Bealing et al. (1996) found that the SEC’s legitimacy was considerably enhanced when
it began issuing enforcement releases. They concluded that by clearly stating the
appropriate audit and accounting procedures that should have been in place but were
not, the SEC established itself as an exemplar “of professional service within public
accounting” and that it was able to protect the investing public through ensuring “full
and fair disclosure to investors of all material facts” (p. 335).
Using institutional theory, it would seem that following the considerable fallout
from the Enron and WorldCom accounting scandals of the early part of this decade, the
SEC would sharpen its focus in pursuing ?nancial statement and accounting fraud.
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Certainly, the pronouncements of politicians (Bush, 2002a, b, c) and the passage of the
Sarbanes-Oxley Act of 2002 re?ect the prevailing environment for major reform of
corporate regulation and a tougher stand generally on unscrupulous behavior by
corporate executives. In such an environment, the SEC would not be immune from
pressure to increase the rate and intensity of its surveillance of company reporting.
This pressure is likely to manifest itself in the AAERs issued post-2001.
3. Research hypotheses and propositions
As noted earlier, a major objective of this study is to identify what key characteristics,
if any, of the AAERs have changed post the period covered by the COSO Report (1999).
We examine whether the changed institutional environment following the accounting
scandals may have impacted on the level of AAERs issuance, the size of companies
subject to AAERS and the nature of the allegations. The following two hypotheses and
four propositions have been developed for this purpose:
H1. There has been an increase in the issuance of AAERs by the SEC in the period
after 2001, that is, post the US accounting scandals.
This H1 is based on the hostile environment faced by the SEC and other regulators in
the wake of Enron, WorldCom and other accounting scandals (Rockness and Rockness,
2005; Bush, 2002a, b, c). Using institutional theory, one would expect to see the SEC
react to this changed environment by actively seeking out new cases of possible fraud
or risk losing its institutional legitimacy (Kondra and Hinings, 1998). Notwithstanding
any possible legitimacy concerns, the post-Enron fallout may act as a signal to the SEC
that its surveillance activities needed to be boosted:
H2. There has beenanincrease inthe size of companies subject toissuance of AAERs
by the SEC in the period after 2001, that is, post the US accounting scandals.
This H2 re?ects the “high pro?le” nature of the major accounting scandals. The COSO
Report (1999) concluded that the vast majority of frauds in its sample involved small
companies. Consistent with institutional theory, one would expect to see that following
the accounting scandals of 2001, the SECwould aggressively pursue “high pro?le” cases
and trumpet any prosecutions as vindication of its pivotal role in ensuring reliable
?nancial disclosures to investors. As noted by de Fond and Smith (1991, p. 144) “the SEC
Enforcement Division chooses cases that enhance its stature as an effective law
enforcement agency”. It follows that larger companies are likely to have been subject to
AAERS since 2001. It may also be plausible that the Enron fallout alerted the SEC to
potentially greater instances of fraud in large companies. It follows that the SEC’s
enforcement activities of larger entities may have increased for this reason post-Enron.
Examples of this increasingly aggressive approach toward “high pro?le” cases are
found in SEC press releases from 2002 onwards. For example, in a 2002 press release
relating to SEC investigations concerning the well publicised case of Tyco
International (SEC, 2002, 2003), the SEC Director of Enforcement is quoted as follows:
This enforcement action is the latest chapter in the Commission’s ongoing investigation,
together with the Manhattan District Attorney, of corruption and self-dealing at the highest
levels of Tyco management [. . .] The Commission today, together with the criminal
authorities, serves notice that misconduct by outside directors, as well as by company
management, will not be countenanced (SEC Press Release Number 2002-177).
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Similarly, an SEC Press Release in 2003 relating to another well publicized fraud,
Vivendi Universal, included the following quote from the Deputy Director of the
Commission’s Division of Enforcement:
This case shows the Commission’s ongoing commitment to enforcing the disclosure
obligations of issuers and it shows our successful use of a new enforcement tool provided by
the Sarbanes-Oxley Act (SEC Press Release Number 2003-184).
The following four research propositions are directly derived from the ?ndings of the
COSO Report (1999). Speci?cally, that report found that many companies committing
the fraud were experiencing net losses or were in close to break-even situations; most
frauds were not isolated to a single ?scal period and large relative to the company size;
the frauds tended to involve improper revenue recognition or overstatement of assets;
and, very senior executives were frequently involved (pp. 5-6):
P1. Companies subject to issuance of AAERs by the SEC are likely to exhibit poor
?nancial condition in the period leading up to the period of alleged accounting
fraud.
P2. The alleged accounting frauds pertaining to companies subject to issuance of
AAERs by the SEC are likely to have occurred over multiple periods and to
involve large amounts relative to the company size.
P3. The alleged accounting frauds pertaining to companies subject to issuance of
AAERs by the SEC are likely to involve improper revenue recognition or
overstatement of assets.
P4. The alleged accounting frauds pertaining to companies subject to issuance of
AAERs by the SEC are likely to have been orchestrated by the most senior
executives of companies, that is, the CEO and the chief ?nancial of?cer (CFO).
4. Research methodology
The present investigators commenced the study by identifying those AAERs that
involved an alleged breach of Rule 10(b)-5 of the US Securities Exchange Act 1934 or
Section 17(a) of the US Securities Act of 1933 or other federal anti-fraud statutes. These
are the sections that represent the primary US antifraud provisions relating to ?nancial
reporting. Excluded from the analysis were restatements of ?nancial reports due to
errors or any activities that did not result in a violation of federal anti-fraud statutes.
This approach was consistent with that of the COSO Report (1999).
The present investigators reviewed 870 AAERs for the four-year period between
January 2002 and December 2005. The search identi?ed 350 AAERs that related to
fraudulent ?nancial reporting between 2002 and 2005 (a period deliberately chosen to
re?ect the post-Enron fallout). However, there were multiple AAERs for some cases
amongst the 350 identi?ed. Where there were multiple AAERs relating to one
company, these were counted as one[1]. This reduced the number of companies to 330.
A random sample of 55 was taken from this group of companies which compares to a
?nal sample of 99 cases for the COSO Report. The Appendix lists each of the 55 cases
used in our sample together with key characteristics of each case[2]. Figure 1 shows a
comparison of the sampling approach used in the present study to that of the COSO
Report (1999).
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In addition to a random sample of all AAERs for the study period, the present study
has adopted the recommendation of O’Connell (2001) in using a sampling approach
which deliberately adds ?ve large “high pro?le” cases of ?nancial statement fraud. The
?ve cases examined are Waste Management, Qwest Communication, Tyco
International, HealthSouth Corporation and Adelphia Communications. These ?ve
cases were widely reported in the media at the time.
This approach avoids the sampling problem of the COSO Report (1999) which led
Briloff (2001, p. 126) to conclude that it was not representative of the “really stinking
stuff which is contaminating the accounting and ?nancial reporting environment”.
As a consequence, of this sampling approach, high-pro?le companies make up
8.3 per cent of the total sample. None of these cases were duplicated in the random
sample. A detailed analysis of the “high pro?le cases” is found later in this paper.
It should be noted that we deliberately did not include Enron and WorldCom in the
sample as we felt that these scandals had already been subject to a considerable
amount of prior research and analysis (Benston and Hartgraves, 2002; O’Connell, 2004).
Accordingly, we think that the facts and circumstances of these two cases are quite
well understood.
There are six key characteristics of AAERs that were speci?cally examined in this
study. All of these six were also studied in the COSO Report (1999): the size of the
company committing the alleged ?nancial statement fraud; the ?nancial condition of
Figure 1.
AAER sample selection
process for present
investigation versus
COSO Report (1999)
COSO report (1999)
(as cited in O’Connell, 2001: 170)
Present study
Approximately 800
AAERs issued in
periods 1987-97
300 firms involved in
"Financial Statement
Fraud"
220 Cases "randomly
selected" from 300
firms
204 cases remain after
16 more cases are
removed "due to data
limitations"
99 cases only where
researchers were able
to obtain "last clean
financial statement"
Approximately 870
AAERs issued in
period 2002-2005
55 Cases
"randomly selected"
from 330 items and
used in the study
Approx 330 firms
involved in "Financial
statement" fraud
5 "High profile" cases
selected and added
to study
Total cases in study 60
Financial
statement fraud
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the company in the period prior to the alleged fraud; which senior executives were
involved in the alleged fraud; the cumulative amount of alleged fraud compared to the
size of the company; whether the alleged fraud covered more than one ?scal period;
and, the typical ?nancial statement fraud techniques involved.
In addition to this analysis of AAERs, we conducted a qualitative content analysis of
the AAERs to ascertain common key motives behind the ?nancial statement frauds.
This latter analysis we believe adds considerably to the richness of our understanding of
the factors behind these phenomena and was not undertaken in the COSOReport (1999).
5. Results and discussion
5.1 SEC issuance of AAERS
Our ?ndings support H1 which proposes that there has been an increase in the
issuance of AAERs by the SEC in the period after 2001, that is, post the US accounting
scandals. The COSO Report (1999) utilised all AAERS issued between January 1987
and December 1997. The authors of that report stated the following:
We read over 800 AAERs, beginning with AAER No. 123 and ending with AAER No. 1004.
From this process, we identi?ed nearly 300 companies involved in alleged instances
of fraudulent ?nancial reporting (p. 12).
The ?nal sample of the COSOReport was then randomly selected fromthat group of 300.
If we compare these ?gures to those of the present investigation, there has been a marked
increase inissuance of AAERs inrecent years. Our analysis reveals that over the four-year
period between 2002 and 2005, a total of 871 AAERs were issued. The breakdown is as
follows: 212 in 2002, 239 in 2003, 220 in 2004 and 200 in 2005. When we identi?ed which of
these AAERs alleged fraud violations related to Rule 10(b)-5 of the 1934 Securities
Exchange Act or Section 17(a) of the 1933 Securities Act, a direct comparison with the
COSO Report approach, we found that 351 had been issued during the study period. The
split is as follows: 95 in 2002, 121 in 2003, 68 in 2004 and 67 in 2005[3].
It follows that the SEC issued AAERs at a far higher rate in the period 2002-2005
when compared to 1987-1997. In just a four-year period almost as many AAERs were
issued as for the entire 11-year period studied by the COSO Report (1999). Furthermore,
those AAERs that speci?cally related to ?nancial statement fraud appeared to
have risen substantially since the 1990s. It should also be noted that many of these
were issued in the period immediately after the scandals, i.e. 2002 and 2003.
These ?ndings could be explained by two possibilities. First, the SEC seeking to
legitimize itself to stakeholders through a greater focus on possible fraudulent ?nancial
reporting. While the SEC did receive an injection of funding from 2002 onwards to
combat corporate fraud (Bush, 2002b) the prevailing climate in the US following the
accounting scandals of 2000-2001 meant that the SEC needed to be seen to be vigilant
in this area. They may have acted as predicted by institutional theory. A second
possible explanation is that the SEC stepped up its enforcement activities post-Enron
following a realization that ?nancial statement fraud was more prevalent than
previously envisaged.
5.2 Size of companies committing ?nancial fraud
A company size (total assets and revenue) comparisons between the COSO Report
(1999) and the present study are shown in Table I.
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Table I.
Total assets and revenue
for sample ?rms in the
COSO Report (1999) and
the present study
Financial
statement fraud
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The COSOReport (1999, p. 5) stated that the “companies committing ?nancial statement
fraud were relatively small” and that “most of the sample companies ranged well below
$100 million in total assets”. As depicted in Table I, the COSOReport (1999) found mean
total assets of companies subject to AAERs were $533 million (median of $15.7 million).
This compares with $3.3 billion (median of $187 million) for the present study. Note that
these numbers do not include the ?ve high-pro?le cases discussed later in this study.
The above ?gures represent a 522 per cent increase in the mean total assets and a 1,092
per cent rise in the median. Turning to total revenues, the COSOReport (1999) portrayed
a mean of $233 million (median of $13 million). This compares with the present study’s
equivalents of $3.1 billion and $62.6 million, respectively. These ?gures depict a 1,232
per cent increase in the mean total revenue and a 380 per cent rise in the median.
It should be noted that we did not conduct statistical comparisons of the two groups
(present study sample versus COSOReport sample) relating to company size because the
authors of the COSOReport (1999) didnot identifywhichspeci?c AAERs were includedin
their analysis[4]. Their report provided only aggregated ?ndings and hence a valid
statistical comparison such as a x
2
-test is impossible. Standard deviations are also not
reported because our sample (together with that of the COSO Report, 1999) is heavily
positivelyskewed. Reliance ona standarddeviationwouldbe misleadinginsucha skewed
distributionandconsequently, medianandquartile results are providedinsteadto provide
a more meaningful picture of the empirical data (Tabachnick and Fidell, 2001).
Clearly, the companies within the COSO Report (1999) sample are considerably
smaller, on average, than those in the present study regardless of whether the samples
are compared on the basis of their means, medians or quartiles. Hence, H2 which states
that there has been an increase in the size of companies subject to issuance of AAERs
by the SEC in the period after 2001 is supported by our results notwithstanding the
inability to conduct a statistical comparison as noted in the previous paragraph.
There are several possible conclusions that can be drawn from these ?ndings. First,
that the COSO Report (1999) sampling approach was skewed towards smaller
companies. However, this seems unlikely as the COSO Report (1999) claims to have
randomly selected its sample so this would suggest that it was representative of the
population of the time. Second, that the SEC deliberately selected larger, more “high
pro?le” companies post-2001 for prosecution consistent with an institutional theory
argument or because they came to the realization that ?nancial statement fraud was
more prevalent in large companies than previously thought. This may be quite
plausible in light of the evidence presented here and the pronouncements of the SEC
mentioned earlier. Third, that the frauds committed post-1998 were generally much
larger than pre-1998. This would seem unlikely. Fourth, potential frauds were less
likely to be detected and/or prevented prior to 2001 and were less likely to be
prosecuted by the SEC especially where larger companies were concerned. Again, this
would seem improbable.
5.3 Pro?tability of companies committing ?nancial fraud
Consistent with the COSO Report (1999), we examined the net income for the year prior
to commencement of the fraud. Our ?ndings are displayed in Table II and show a far
higher net income ?gure for our sample (mean of $48.3 million and median of $1.8
million) when compared to the COSO Report (mean of $8.6 million and median of
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$175,000). This represents a 463 per cent increase in the mean and a 929 per cent
increase in the median[5].
These ?ndings contrast somewhat with the COSO Report (1999, p. 5) which
concluded that “pressures of ?nancial strain or distress may have provided incentives
for fraudulent activities for some fraud companies”. Companies in the present
investigation were generally pro?table in the lead up period to the fraud so the
incentive to commit fraud appears to have come from other factors. In fact, only 14 out
of 55 of our sample (25.5 per cent) reported a loss in the period immediately prior to the
alleged fraud. These ?ndings do not support proposition one which stated that
companies subject to issuance of AAERs by the SEC are likely to exhibit poor ?nancial
condition in the period leading up to the period of alleged accounting fraud.
Our qualitative analysis of AAERs provided valuable insights into why executives
in the sample resorted to ?nancial statement fraud despite many of the sample being
quite pro?table entities. It is apparent that pressure to achieve Wall Street analysts’
pro?t forecasts was a recurring theme at the heart of many of these frauds and was
commonly mentioned in the AAERs:
RSA stated that it had achieved analysts’ earnings expectations for the ?rst quarter of 2001
[. . .] without the accounting change [a new, aggressive method of recognizing sales for
shipments to distributors] RSA would have failed to meet analysts’ earnings expectations by
approximately $0.02 per share or 12.5 %, and its operating income would have been 17.3 %
lower (AAER No. 1817, RSA Security, 23 July 2003).
In the Spring of 1999, Miller [former CEO] devised and implemented a scheme to fraudulently
overstate the company’s net income to meet analysts’ expectations. Pursuant to the plan, the
company fraudulently reclassi?ed rent and salary expenses that Master Graphics had already
paid to its division presidents in the ?rst quarter to assets on the company’s balance sheet thus
reducing expenses and increasing income (AAER No. 2035, Master Graphics, 14 June 2004).
5.4 Stockholders’ equity (de?cit) of companies committing ?nancial fraud
Our analysis of stockholders’ equity in the period preceding the ?nancial fraud reveals a
similar picture to that of the pro?tabilityanalysis. As shown inTable III, the COSOReport
(1999) reported a mean stockholders’ equity of $86.1 million (median of $5 million).
Our investigation shows a mean stockholders’ equity of $735.1 million (median of $58.2
million). These ?ndings re?ect a 753 per cent higher mean and a 1,062 per cent larger
median for the sample in the present study. Again, P1 is not supported by these ?ndings.
Net income/loss (in $ 000’s)
COSO Report (1999) This study
n ¼ 99 n ¼ 55 Percentage of change
Mean 8,573 48,274 463.1
Median 175 1,802 929.7
Minimum value (37,286) (879,555)
First quartile (448) (1,678) 274.6
Third quartile 2,164 45,678 2,010.1
Maximum value 329,000 1,206,000
Note: Figures were taken from the last ?nancial statement prior to fraud
Table II.
Net income for sample
?rms in the COSO Report
(1999) and the present
study
Financial
statement fraud
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5.5 Executives named in the AAERs
Table IV depicts that there is a marked difference in the results obtained in the present
study and those found in the COSO Report (1999). The COSO Report (1999) found that
the CEO (141 companies or 72 per cent of the sample) was the highest ranking
executive involved in most fraud cases[6]. In the present investigation, the senior
executive most frequently named was the CFO (33 companies representing 60 per cent
of the sample). There also seems to be a greater spread of individuals cited in this
study. The controller (13 per cent of sample), chief operating of?cer (COO) (16 per cent)
and other vice president positions (20 per cent) were commonly mentioned in the
AAERs. However, it should be noted that the companies in our sample are, on average,
much larger than that of the COSO Report (1999). Hence, this greater spread of accused
may simply re?ect the greater size and complexity of the companies in our study. Our
?ndings generally support proposition four which states that the frauds are likely to
have been orchestrated by the most senior executives of companies, that is, the CEO
and the CFO. As Table IV shows this is clearly the situation in most cases.
Our qualitative analysis of AAERs offers important insights into the direct
involvement of unscrupulous senior executives in many of the frauds:
Stockholders’ equity (de?cit) (in $ 000’s)
COSO Report (1999) This study
n ¼ 99 n ¼ 55 Percentage of change
Mean 86,107 735,084 753.7
Median 5,012 58,237 1,062.0
Minimum value (4,516) (467,706)
First quartile 1,236 7,838 534.1
Third quartile 17,037 230,030 1,250.2
Maximum value 2,772,000 12,785,239
Note: Figures were taken from the last ?nancial statement prior to fraud
Table III.
Stockholders’ equity
(de?cit) for sample ?rms
in the COSO Report
(1999) and the
present study
Types and frequencies of individuals named
COSO Report (1999) This study
No. of
companies
Percentage of fraud
cases
No. of
companies
Percentage
of fraud cases
Chief executive of?cer 141 72 26 47
Chief ?nancial of?cer 84 43 33 60
Controller 41 21 7 13
Chief operating of?cer 13 7 9 16
Chief accounting of?cer 0 0 3 5
Other vice president positions 35 18 11 20
Board of directors 21 11 6 11
Lower level personnel 19 10 1 2
Outsiders (e.g. auditors and
customers) 74 38 1 2
No title given 30 15 1 2
Other titles 24 12 6 11
Table IV.
Types and frequencies of
individual executive
positions named in
AAERs for sample ?rms
in the COSO Report
(1999) and the
present study
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Signal Tech’s former management created a corporate atmosphere which encouraged
managers to engage in improper accounting in an effort to improve Signal Tech’s bottom line.
Signal Tech’s former chairman and other senior of?cers expressed scorn for accounting
principles. [. . .] As a result of the pressure for pro?ts at all costs and disdain for accounting
principles by former senior of?cers [. . .] Keltec’s controller knowingly allowed improper
accounting practices [. . .] Moreover, Signal Tech’s senior of?cers personally directed speci?c
improper accounting practices and dictated misleading entries to be made on Keltec’s books to
overstate revenue and understate costs (AAER No. 1534, Signal Technology, 27 March 2002).
During the ?rst and second quarters of 2000, the CFO placed substantial pressure on the
Controller to continue to meet analysts’ earnings expectations in reported results. As a result
of that pressure, the Controller intentionally failed to record certain operating expenses which
were material to both quarters (AAER No. 1691, Mercator Software, 16 December 2002).
5.6 Cumulative dollar amount of fraud for a company
As shown in Table V the average fraud amount in our sample involved $137 million of
cumulative misstatement or misappropriation (median of $10.8 million)[7]. This is much
higher than those found in the COSOReport (1999) where a mean and median of $25 and
$4.1 million, respectively, were reported. This comparison indicates a 448 per cent
increase in the mean size of the fraud and a 163 per cent rise in the median. Moreover, the
cumulative amounts of the fraud were quite high relative to the size of the company. The
median fraud of $4.1 million for the COSO Report (1999) sample represented 25 per cent
of median total assets ($15.7 million). In our sample, the median fraud of $10.8 million
represented 6 per cent of median total assets ($186.9 million). In both samples, the
median fraud amount considerably exceeded the median net income. It follows that P4 is
supported as the frauds do, on average, involve large amounts relative to company size.
Qualitative analysis of the AAERs shows a recurring theme that the SEC contended
that a key motivation of executives to manipulate reported earnings was that these
actions were likely to have a signi?cant impact on the share price and associated
bonuses of executives. While such a contention cannot be proven without conducting
interviews of executives under investigation, the tone of AAERs strongly indicate this
motive may have been a signi?cant factor in the frauds:
The compliant alleges that Gless [former CFO] and other Peregrine senior of?cers engaged in
deceptive practices to arti?cially in?ate Peregrine’s revenue and stock price, and that Gless
then took fraudulent action to conceal the scheme (AAER No. 1759, Peregrine Systems,
16 April 2003).
Cumulative fraud amount (in $ 000’s)
COSO Report (1999) This study
n ¼ 99 n ¼ 55 Percentage of change
Mean 25.0 137.0 448.0
Median 4.1 10.8 163.4
First Quartile 1.6 million 3.95 million 146.9
Third Quartile 11.76 million 53.6 million 355.8
Smallest Fraud 20 50 150
Largest Fraud 910,000 3,000,000 229.7
Note: Figures were taken from AAERs
Table V.
Cumulative fraud amount
for sample ?rms in the
COSO Report (1999) and
the present study
Financial
statement fraud
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In 2001 and 2002 Huntington reported in?ated earnings in its ?nancial statements, enabling
Huntington to meet or exceed Wall Street analyst earnings per share expectations and
internal EPS targets that determined bonuses for senior management (AAER No. 2251,
Huntington Bancshares, 2 June 2005).
5.7 Length of fraud period
The COSO Report (1999, p. 30) found that the average fraud was for two years with a
median of 21 months. Table VI indicates that 36 per cent of frauds in the current study
related to one year or less with 36 per cent between one and two years, and 18 per cent
lasting for three years. In all, 64 per cent of all frauds in our sample were for greater
than one year. These results are consistent with P2 in indicating that many frauds
occur across multiple periods.
5.8 Common ?nancial fraud techniques
As can be seen in Table VII, by far the most common technique used to fraudulently
misstate ?nancial statement information in our sample involved deliberate
overstatement of revenue. In fact, 96 per cent of alleged fraud involved this method.
In the COSO Report (1999), 50 per cent of the sample employed this method suggesting
either the SEC has deliberately increased its surveillance activities in this area or that
this type of fraud has become far more prevalent since the 1990s. The second most
common technique to fraudulently misstate ?nancial statement information was the
overstatement of assets (53 per cent). However, the use overstatement of assets and
understatement of expenses/liabilities have remained relatively consistent across the
two periods. Misappropriation of assets has declined somewhat across the two periods
(down from 40 per cent in the COSO Report to 11 per cent in the present study). The
above ?ndings support P3 in that the sample frauds commonly involved improper
revenue recognition or overstatement of assets.
Our qualitative analysis of AAERs provided detailed descriptions of the types of
techniques employed by executives to misrepresent the company’s ?nancial
performance. The deliberate overstatement of revenue stands out as the preferred
option for accounting fraud:
[Senior executives] falsely reported millions of dollars of non-existent sales, including sales to
a ?ctitious customer, and used other fraudulent techniques to in?ate Anicom’s revenues’
(AAER No. 1554, Anicom, 6 May 2002).
During the period from January 1996 through June 1998, Signal Tech’s Keltec division
prematurely recognized revenue, failed to record contract losses and failed to write down
Financial periods (years) covered by fraud Number of sample Percentage of total sample
One year 20 36
Two years 20 36
Three years 10 18
Four years 2 4
Five years 3 6
Notes: Figures were taken from AAERs, n ¼ 55 companies; the COSO Report (1999) did not provide
data on this variable broken down as above; however, the COSO Report (1999, p. 30) reports that
14 per cent of the frauds were for one year or less with an average period of approximately two years
Table VI.
number of ?nancial
periods (years) covered
by fraud for sample ?rms
in the present study
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excess inventory. Signal Tech’s former Chairman and CEO, former CFO, and other former
senior corporate of?cers, knew of and in multiple instances personally directed improper
accounting practices. On several occasions the former chairman and other senior of?cers even
dictated speci?c misleading entries to be made on Keltec’s books (AAER No. 1534, Signal
Technology, 16 December 2002).
6. Analysis of ?ve high-pro?le companies
Two of the main criticisms of the COSO Report (1999) by Briloff (2001) and O’Connell
(2001) are a paucity of “high pro?le” cases in that sample and the lack of disclosure of
the speci?c AAERs scrutinized by those investigators. In contrast, the present study
provides details of all AAERs examined (see the Appendix) and uses a sampling
approach that speci?cally includes an analysis of ?ve high-pro?le cases during the
study period. The ?ve frauds examined are Waste Management, Qwest
Communication, Tyco International, HealthSouth Corporation and Adelphia
Communications. They are considered to be high pro?le in the sense that they were
widely cited in the media as examples of fraud.
Table VIII displays a summary of the key characteristics of the ?ve major frauds.
Table VIII shows that these ?ve companies were large varying from a minimum of
$1.6 billion in total assets through to a maximum of $8.1 billion (mean of $4.6 billion).
The accumulated amount of the frauds was also sizeable varying from a minimum of
$567 million through to a maximumof $3.5 billion (mean of $1.9 billion). It should also be
noted that these fraud amounts were signi?cant when compared to each company’s
revenue or pro?t situation. For example, in60 per cent of the cases the accumulated fraud
COSO Report (1999) Present study
Percentage of sample using
fraud method
Percentage of sample using
fraud method
Methods used to misstate ?nancial
statements
Sub-
category (%)
Overall
category (%)
Sub-
category (%)
Overall
category (%)
Improper revenue recognition 50 96
Recording ?ctitious revenues 26 36
Recording revenues prematurely 24 36
No description/overstated 16 23
Overstatement of assets (excluding
accounts receivable overstatements
due to revenue fraud)
50 53
Overstating existing assets 37 35
Recording ?ctitious assets or assets
not owned
12 7
Capitalizing items that should be
expenses
6 11
Understatement of expenses/liabilities 18 24
Misappropriation of assets and other
miscellaneous techniques
40 11
Notes: Figures were taken from AAERs; COSO Report (1999) n ¼ 204; present study n ¼ 55;
subcategories such as “Recording ?ctitious revenues” and “Capitalizing expenses” do not sum to the
overall category totals due to multiple types of fraud involved at a single company, so, for example,
a company could have recorded revenues both ?ctitiously and recorded prematurely
Table VII.
Common ?nancial
statement fraud
techniques used by
sample ?rms in the COSO
Report (1999) and the
present study
Financial
statement fraud
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Table VIII.
Summary of key
characteristics of ?ve
major frauds during the
study period
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amount exceeded the company’s total revenue from the previous year’s ?nancial result.
In all cases, the frauds covered several reporting periods with a minimum of four years
and a maximumof 7.5 years (mean of 5.5 years). The CEOwas implicated in the fraud in
all cases with the CFO prosecuted in 80 per cent of them. In 40 per cent of the cases, the
company was quite pro?table in the year preceding the fraud (as measured by net
income). In another 40 per cent, the company reported a large loss the previous year and
in the remaining case the company reported a small loss. Arti?cial in?ation of reported
earnings was at the centre of the prosecution in all but one of the cases.
Our qualitative analyses of the AAERs show that an inappropriate “tone at the top”
was a key issue in most of these cases:
The business unit executives made it clear that subordinates had to meet or exceed these
aggressive earnings targets at all costs (AAER No. 2209, Qwest Communications
International, issued 15 March, 2005).
Senior of?cers of the Company would, on a quarterly basis present the CEO with an analysis
of the company’s actual but, as yet, unreported earnings for the quarter as compared to Wall
Street’s expected earnings for the Company. If the actual ?nancial results of HealthSouth fell
short of analyst expectations, the CEO would tell his executives to “?x it” by recording false
earnings on HRC’s accounting records to make up the shortfall.
Treating company funds as though they were entitlements of senior executives was
another theme:
The SEC charged that Adelphia, at the direction of the individual defendants [. . .] concealed
rampant self-dealing by the Rigas Family, including the undisclosed use of corporate funds
for Rigas family stock purchases and the acquisition of luxury condominiums in New York
and elsewhere (AAER No. 1599, Adelphia).
This is a looting case [. . .] it involves egregious, self-serving and clandestine misconduct by the
three most senior executives at Tyco (AAERNo. 1839, Tyco International, issuedAugust 13, 2003).
The ubiquitous issue of pressure to appease analysts’ forecasts also was a common
theme:
The complaint was that these eight of?cers arti?cially accelerated Qwest’s recognition of
revenue in two equipment sale transactions for its Global Business Markets Unit It is alleged
that that when the Qwest ?nancial management indicated the company would miss its
quarterly targets, the Global Business Markets of?cers would bridge the gap by fraudulently
mischaracterizing these transactions (AAER No. 1726, Qwest Communications, issued
February 25, 2003).
Common approaches to perpetrating the accounting fraud were revenue and expense
manipulation:
To summarize the charges of improper accounting practices, the defendants “resorted to
improperly eliminating and deferring current period expenses to in?ate earnings.” Such
practices included: avoiding depreciation expenses on their garbage trucks; assigning
arbitrary salvage values to other assets that previously had no salvage value; failing to record
expenses for decreases in the value of land?lls as they were ?lled with waste; refusing to
record expenses necessary to write off the costs of unsuccessful and abandoned land?ll
development projects; establishing in?ated environmental reserves (liabilities) in connection
with acquisitions so that the excess reserves could be used to avoid recording unrelated
operating expenses; improperly capitalizing a variety of expenses; and, failing to establish
Financial
statement fraud
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suf?cient reserves (liabilities) to pay for income taxes and other expenses (AAER No. 2116,
Waste Management).
The entries designed to perpetrate the fraud primarily consisted of reducing a contra revenue
account called “contractual adjustment” and/or decreasing expenses (either of which
increased earnings) and correspondingly increasing assets or decreasing liabilities (AAER
No. 1744, HealthSouth Corporation).
In summary, the ?ndings from these ?ve high-pro?le cases largely support those of the
55 randomly selected cases. The extent and nature of the frauds was signi?cant and
the companies involved were substantial in size with senior executives treating the
company’s funds as if they were their own.
7. Conclusion
This study set out to examine the US SEC’s investigations into ?nancial statement
fraud through an analysis of AAERs from 2002 to 2005. Findings were compared to the
COSO Report which examined AAERs from 1987 to 1997. Using an institutional theory
framework it was hypothesized that the post-Enron environment may have brought
about changes in the activities of the SEC in an effort for this agency to legitimize itself
before major stakeholders. Our study did ?nd evidence of changes when compared to
the COSO Report (1999). Speci?cally, we found that there far more AAERs issued
post-Enron and the companies involved were, on average, much larger, more pro?table
and the frauds more substantial than those exhibited in the COSO Report (1999). These
?ndings hold even before considering the additional ?ve high-pro?le cases that we
added to accommodate the recommendation of Briloff (2001). Our results suggest that
the SEC became more aggressive at pursuing larger companies for ?nancial statement
fraud in the post-Enron environment than perhaps was the case in the 1990s.
Our study has also addressed a major criticism of the COSO Report (1999) by Briloff
(2001) and O’Connell (2001), namely, that there were an insuf?cient number of “high
pro?le” companies included in the sample of the COSO Report (1999). We believe that
the addition of case studies on ?ve major accounting frauds to 55 randomly selected
cases addresses those criticisms of the COSO Report (1999).
There are several important implications of this research. First, while the COSO
Report (1999, p. 5) concluded companies committing ?nancial statement fraud tend to
be small this certainly does not appear to be the case based on our more recent sample.
In fact, it would seem that accounting frauds often involve large companies with the
most senior executives implicated. These frauds often cross several reporting periods.
A second key implication is that, rather than being motivated to hide losses, the
frauds appear to be a mechanism for boosting reported earnings to appease Wall Street
analysts. The motivation for this appears to be ensuring a rising stock price and thus
increased executive remuneration. This evidence from the AAERs would seem to show
that devices designed to reduce agency costs such as stock options have provided a
perverse incentive for some executives to do whatever it takes, including fraud, to
boost the stock price in the short-term. A third implication is that improper revenue
recognition through recording ?ctitious revenues or recording revenues prematurely
continues to be the preferred methods for deception. Auditors and analysts alike need
to remain vigilant in searching for any signs of such reprehensible actions by
management.
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Many of these ?ndings appear to be highly relevant in considering the incidence of
?nancial statement fraud globally. Securities markets regulators, auditors and
?nancial analysts to name a few would bene?t from consideration of these ?ndings.
There are some limitations to the present study that should be recognized. First,
AAERs tend to be uneven in their level of disclosure and format thus making some more
useful for analysis purposes than others. It is apparent from both the COSO Report
(1999), and the present study, that to enhance the usefulness of AAERs for analysis
purposes, the SEC needs to improve their comparability in relation to language,
structure and content. Second, there is a possibility of selection bias by relying on
AAERs as the primary data source for ?nancial statement fraud. This is because
AAERs mayre?ect the prevailingagenda of the SEC(Bonner et al., 1998) or differ intheir
nature or severity (Feroz et al., 1991). Notwithstanding, these limitations AAERs have
been widely applied by researchers as a reasonably objective and reliable data source for
studying fraud (de Fond and Smith, 1991; Bonner et al., 1998). Third, the observed rise in
enforcement actions and the size of ?rms prosecuted may be explained by a variety of
factors other than legitimization such as a greater awareness of the possibility of fraud
post-Enron. Fourth, if one accepts that the COSOReport (1999) possessed weaknesses in
its sampling approach then it may not be an accurate source of comparison for studying
changes in the SEC’s enforcement activities over the period. Fifth, the level of statistical
comparison of the two samples possible was limited by the unavailability of detail on the
COSO sample. However, the large differences across the two samples in descriptive
statistics such as means suggest a highly likelihood of statistically signi?cant
differences if the data were able to be analysed in this way. Certainly, the differences
between the two samples are of great practical relevance.
Avenues for future research include more case-based research into ?nancial
statement fraud using a variety of sources such as company documents, court cases,
judgments and interviews. It would also be useful to conduct interviews with
surveillance personnel of the corporate regulator to ascertain information about
prevailing enforcement agendas and processes and their speci?c impact on enforcement
activities. Industry-based comparisons may also provide interesting insights.
Notes
1. In some cases a separate AAER was issued for the company and for each individual
executive involved in the accounting fraud.
2. Briloff (2001) was highly critical of the absence from the COSO Report (1999) of such a list.
3. It should be noted that the COSO Report (1999) did not report a year-by-year dissection of
AAERs.
4. The authors contacted the authors of the COSO Report in an effort to obtain details of the
sample used by them. We were informed that due to con?dentiality requirements by the
Treadway Commission they would be unable to divulge this information.
5. We cannot discount that some of these ?rms may have practiced earnings management in
the periods leading up to the alleged ?nancial statement fraud so these ?gures may be
overstated. However, it would seem likely that the level of overstatement would be similar
across the two periods of analysis.
6. It should be noted that in determining Table IV, the highest managerial title for an
individual was used.
Financial
statement fraud
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7. It should be noted that on a few occasions the AAERs did not fully disclose the quantum of
dollars relating to the fraud. Accordingly, we conducted additional research through the
SEC’s Litigation Releases et al. (available at: www.sec.gov/litigation/litreleases.shtml)
to ascertain the precise fraud amount.
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Financial
statement fraud
139
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Further reading
Bailey, J. (2000), “Waste management settles SEC charges that it misled investors in spring of
’99”, Wall Street Journal, p. B.20, 22 June, available at: http://proquest.uni.com/pqdweb?
index¼105&sid¼1&srchmode¼1&vinst¼PROD&fm (accessed 21 June 2006).
Berman, D.K. and Solomon, D. (2003), “Qwest may settle SEC swaps case – potential charges of
fraud relate to ?ber-optic deals with other telecom ?rms”, Wall Street Journal, p. A.3,
9 May, available at: http://proquest,uni.com.elibrary.jcu.edu.au/pqdweb?index¼1&sid
¼4&srchmode¼1&v (accessed 21 June 2006).
O’Connell, B., Webb, L. and Schwarzback, H. (2005), “Batten down the hatches! US accounting
scandals and lessons for Australia”, Australian Accounting Review, Vol. 15 No. 2, pp. 52-67.
Perell, P.M. (2006), “Deceived with ornament: law, lawyers and Shakespeare’s The Merchant of
Venice”, available at: www.lsuc.on.ca/media/third_colloquium_paul_perell.pdf (accessed
17 January 2007).
University of California (2005), “Federal court approves dynergy securities fraud settlement”,
University of California, Oakland, CA, 8 July, Press Release, available at: www.
universityofcalifornia.edu/news/2005/jul08C.html (accessed 25 May 2006).
Weld, L.G., Bergevin, P.M. and Magrath, L. (2002), “Anatomy of a ?nancial fraud, a forensic
examination of HealthSouth”, The CPA Journal, August, available at: www.nysscpa.org/
printversions/cpaj/2004/1004/p44.htm (accessed 25 May 2006).
About the authors
Richard Lane, MBA, CA, has had extensive years of experience in public practice including being
the Principal of his own accounting ?rm in North Queensland. In recent years, he has worked as
both a Financial Controller for an exporting company and as a Lecturer in Accounting at James
Cook University.
Brendan T. O’Connell, PhD (Monash), CPA, CMA, F Finsia, has extensive teaching and
research experience in leading Australian and US Universities including Monash University, the
University of Richmond in Virginia, Deakin University and James Cook University. He has
published numerous papers in leading academic journals such as the Journal of Accounting
Auditing and Finance, Abacus, Critical Perspectives on Accounting, Issues in Accounting
Education, the Australian Accounting Review and the Journal of Applied Finance on topics such
as earnings management, ?nancial statement fraud, business ethics and securitisation. He is also
Guest Editor of a special issue of Critical Perspectives on Accounting entitled “Enron.con” and a
special issue of Accounting History that provides an historical perspective to accounting and
audit failure within corporate collapse. He is also a member of the editorial board of the
Australian Accounting Review. His case studies on the collapses of Enron and HIH Insurance now
form part of the CPA Program in Australia. He is also a Chief Examiner for the foundation
segment of the CPA Program in Australia. Prior to working in academia, he worked in the
investment banking industry with Bankers Trust Australia, as a ?nancial analyst with the ANZ
Banking Group Ltd, and in corporate recovery with Pannell Kerr Forster. Brendan T. O’Connell
is the corresponding author and can be contacted at: [email protected]
To purchase reprints of this article please e-mail: [email protected]
Or visit our web site for further details: www.emeraldinsight.com/reprints
ARJ
22,2
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Table AI.
Financial
statement fraud
143
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This article has been cited by:
1. Daniella Juric, Brendan O’Connell, Michaela Rankin, Jacqueline Birt. 2015. Determinants of the Severity
of Legal and Employment Consequences for CPAs Named in SEC Accounting and Auditing Enforcement
Releases. Journal of Business Ethics . [CrossRef]
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doc_662581877.pdf
This paper builds on the Committee of Sponsoring Organizations (COSO) Report, which
examined US Accounting and Auditing Enforcement Releases (AAERs). The purpose of this paper is
to provide valuable insights into the characteristics and realities of financial statement fraud in the
post-Enron regulatory environment.
Accounting Research Journal
The changing face of regulators' investigations into financial statement fraud
Richard Lane Brendan T. O'Connell
Article information:
To cite this document:
Richard Lane Brendan T. O'Connell, (2009),"The changing face of regulators' investigations into financial
statement fraud", Accounting Research J ournal, Vol. 22 Iss 2 pp. 118 - 143
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http://dx.doi.org/10.1108/10309610910987484
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The fulltext of this document has been downloaded 2491 times since 2009*
Users who downloaded this article also downloaded:
Rodney L. Crawford, Thomas R. Weirich, (2011),"Fraud guidance for corporate counsel reviewing
financial statements and reports", J ournal of Financial Crime, Vol. 18 Iss 4 pp. 347-360 http://
dx.doi.org/10.1108/13590791111173696
G. Stevenson Smith, (2012),"Can an auditor ever be a first responder to financial frauds?", J ournal of
Financial Crime, Vol. 19 Iss 3 pp. 291-304 http://dx.doi.org/10.1108/13590791211243138
Cenap Ilter, (2014),"Misrepresentation of financial statements: An accounting fraud case from Turkey",
J ournal of Financial Crime, Vol. 21 Iss 2 pp. 215-225 http://dx.doi.org/10.1108/J FC-04-2013-0028
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The changing face of regulators’
investigations into ?nancial
statement fraud
Richard Lane
School of Business, James Cook University, Townsville, Australia, and
Brendan T. O’Connell
School of Accounting and Law, RMIT University, Melbourne, Australia
Abstract
Purpose – This paper builds on the Committee of Sponsoring Organizations (COSO) Report, which
examined US Accounting and Auditing Enforcement Releases (AAERs). The purpose of this paper is
to provide valuable insights into the characteristics and realities of ?nancial statement fraud in the
post-Enron regulatory environment.
Design/methodology/approach – This paper analyses a sample of AAERs from 2002 to 2005.
It also provides case studies of an additional ?ve high-pro?le case studies from that period.
Findings – This paper ?nds evidence of changes in Securities and Exchange Commission (SEC)
enforcement activities since the COSO Report. Speci?cally, it is found that enforcement activities have
increased substantially post-Enron and the companies subject to AAERs are, on average, much larger,
more pro?table and the frauds are more substantial than those exhibited in the COSO Report. These
?ndings suggest that the SEC has become more aggressive at pursuing larger companies for ?nancial
statement fraud in the post-Enron environment.
Research limitations/implications – This paper relies on AAERs as the source of analysis of
?nancial statement fraud, its ?ndings must be viewed in light of the limitations of using these
documents. Speci?cally, the prevailing prosecutions agenda of the US SEC may be re?ected in these
results.
Practical implications – The study ?ndings are of great practical relevance to accounting
regulators and practitioners as they provide valuable insights into the nature and characteristics of
?nancial statement fraud.
Originality/value – The paper provides empirical evidence concerning the changing face of ?nancial
statement fraud enforcement and provides a more in-depth comparison of fraud than possible with most
previous studies that have tended to focus on quantitative measures. This is possible because the
present investigation utilises qualitative data from AAERs to supplement quantitative ?ndings.
Its originality is also due to the use of institutional theorywhichis not commonly appliedinthe corporate
governance ?eld.
Keywords Organizational analysis, Financial reporting, Fraud, United States of America, Accounting,
Auditing
Paper type Research paper
1. Introduction
This analysis of the US Securities and Exchange Commission’s (SEC’s) Accounting
and Auditing Enforcement Releases (AAER’s) seeks to provide valuable insights into
the characteristics and realities of ?nancial statement fraud within US companies
during the period 2002-2005. While the data set for this study is drawn from the USA,
we believe that the ?ndings have strong relevance for all developed capital markets
and their regulators; including Australia. Employing a cross-case analysis of AAERs,
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1030-9616.htm
ARJ
22,2
118
Accounting Research Journal
Vol. 22 No. 2, 2009
pp. 118-143
qEmerald Group Publishing Limited
1030-9616
DOI 10.1108/10309610910987484
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our study documents how senior management of these companies deliberately sought
to hide the realities of their company’s performance from stakeholders often across
many years. In this way, we aim to enhance understanding of key characteristics of
?nancial statement frauds such as their size and the length of their perpetration.
In addition to the above objective, the present investigators also seek to compare our
?ndings with those reported by the Committee of Sponsoring Organizations (COSO) of
the Treadway Commission 1987-1997 (COSO Report, 1999). Speci?cally, we aim to
compare common characteristics of ?nancial statement fraud pre and post issuance of
that report and whether the focus of SEC prosecutions has changed over that period.
The rationale for this comparison is to study whether “high pro?le” accounting
scandals such as Enron and WorldCom have resulted in changes to the foci of
investigations conducted by the SEC and the targets of those investigations.
The present study contributes to the literature in three major ways. First, it provides
empirical evidence concerning the changing face of ?nancial statement fraud
enforcement. Second, it provides a more in-depth comparison of fraud than possible
with most previous studies that have tended to focus on quantitative measures. This is
possible because the present investigation utilises qualitative data from AAERs to
supplement quantitative ?ndings. Third, in using institutional theory it applies a
theoretical framework that is not commonly applied in the corporate governance ?eld
which tends to emphasise agency and transaction cost perspectives (Peasnell et al., 2005;
Lin, 2008).
As noted above, the theoretical basis of our study is drawn from institutional theory.
Institutional theory adopts an open system perspective where organizations are
strongly in?uenced by their environments (DiMaggio and Powell, 1983; Bealing et al.,
1996). We hypothesize that, post-2001, the SEC responded to the voluminous criticismof
regulation of companies emanating fromthe major accounting scandals by signi?cantly
increasing the number and scale of its enforcement activities to ensure maintenance of
its societal legitimacy.
2. Literature review
2.1 COSO Report
In 1999, the COSO of the Treadway Commission released the study, Fraudulent
Financial Reporting: 1987-1997, an analysis of US Public Companies (COSO Report,
1999). The report has since been widely circulated and cited (Wells, 2001; Beasley et al.,
2000). The COSO Report (1999, p. 1) boasted that, “For the ?rst time, we have a clear
understanding of the who, why, where and how of ?nancial reporting fraud”. These
researchers analysed AAERs issued by the SEC over an 11-year period between
January 1987 and December 1997. The subject of their analyses were instances of
alleged violations of Rule 10(b)-5 of the 1934 Securities Exchange Act or Section 17(a)
of the 1933 Securities Act, they being the main anti-fraud provisions that relate to
?nancial statement reporting. A random sample of 220 cases of ?nancial statement
fraud were subjected to analysis, however, the researchers found that only in 99 cases
were they able to obtain the “last clean ?nancial statements” (p. 15).
Major ?ndings of the COSO Report were that the companies involved in ?nancial
statement fraud tended to be relatively small; some companies committing the fraud
were experiencing net losses or were close to break-even prior to the fraud; top senior
executives were frequently involved; cumulative amounts of fraud were relatively
Financial
statement fraud
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large relative to company size and were not isolated to a single period; and, typical
fraud techniques involved overstatement of revenues (COSO Report, 1999, pp. 5-6).
2.2 Incentives to manipulate accounting earnings
The ?ndings of the COSO Report should also be considered in light of a number of
studies that have examined the incentives for ?nancial statement fraud and/or earnings
management (Dechow et al., 1996; Graham et al., 2005). A brief overview follows. There
are several motivations for why managers might manipulate reported earnings to
achieve some aim such as achieving an earnings target, employee bonuses, bond
covenants, stakeholder motivations and stock price motivations. Broadly, the literature
to date has found that companies generally just beat earnings benchmarks such as stock
analysts’ consensus estimates (DeGeorge et al., 1999), the share price tends to react very
adversely to negative earnings surprises (Barth et al., 1999), ?rms can enhance their
reputationwithstakeholders suchas customers by managing earnings (Burgstahler and
Dichev, 1997) and managers exercise accounting discretion to maximise bonuses (Healy,
1985). However, there is no evidence that earnings are managed to reduce the probability
of violating a covenant (Watts and Zimmerman, 1990).
Two studies of particular interest to the present study are Graham et al. (2005) and
Dechowet al. (1996) given that they focussed on the views of ?nancial executives or were
sourced directly from AAERs. Graham et al. (2005) surveyed over 400 US ?nancial
executives and found disturbingly that poorly performing ?rms are likely to take
measures to delay bad news, that reported earnings rather than cash?ows are the major
metric analysed by stakeholders, meeting or exceeding benchmarks is very important to
executives’ credibility, executives prefer smooth rather than volatile earnings, and that
they feel pressure to take decisions that may sacri?ce long-term value to meet earnings
targets. Mechanisms used to meet benchmarks would include a range of accounting
discretionary choice such as changing in accounting assumptions together with
discretionary spending choices such as deferral of investment projects.
Dechow et al. (1996) examined US ?rms subject to AAERs and found that ?rms
manipulating earnings are more likely to: have boards of directors dominated by
management, a chief executive of?cer (CEO) who is also chairman of the board and a
CEO who also happened to found the ?rm. They are less likely to have an audit
committee and an outside blockholder.
2.3 Criticisms of AAERS and the COSO Report
There have been several studies utilising AAERs which have evaluated their
limitations (Feroz et al., 1991; Bonner et al., 1998) and critiques of the COSO Report
(1999) itself (Briloff, 2001; O’Connell, 2001). In terms of the limitations of AAERs
themselves, Feroz et al. (1991) reported that SEC enforcement actions differ in their
nature and severity. Bonner et al. (1998) recognized this problem and attempted to
control for differences in severity by assigning each action a value for severity from the
external auditor’s perspective. Bonner et al. (1998, p. 505) also emphasized the strong
possibility of selection bias emanating from reliance on AAERs. They speci?ed that
these enforcement actions might re?ect speci?c SEC agendas prevailing at the time of
the sample selection. If this is the case, sole reliance on enforcement actions might not
produce a sample of frauds that is truly representative of the entire population of
?nancial statement frauds.
ARJ
22,2
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The SEC (1989, p. 1) admits that its enforcement program is designed to
“concentrate on particular problems areas and to anticipate emerging problems”. As an
example of this SEC agenda bias, Feroz et al. (1991) reported that 70 per cent of all
AAERs issued between 1982 and 1989 related to alleged overstatement of accounts
receivables and inventories by ?rms. Furthermore, Feroz et al. (1991, pp. 111-2)
highlighted that interviews with current and former SEC of?cials show that the SEC
has more targets for formal investigations than it can practically pursue and that they
need to limit their investigations to instances where material violations are alleged to
have occurred. They noted that formal investigations are both costly and highly visible
and this means that the SEC is forced to rank candidates for formal investigation
“according to the probability of success and potential message value” (Feroz et al.,
1991, p. 112).
Turning to evaluation of the COSOReport (1999) itself, perhaps the most high pro?le
of these critiques was Briloff (2001). Key aspects of his criticism were that the selection
process produced a group of companies that were not representative of the high-pro?le
cases that, in his view, were “contaminating the accounting and ?nancial reporting
environment” (p. 126). Briloff was especially critical of the obvious lack of high-pro?le
cases in the sample given the small size of companies re?ected in the demographic data
of the study. Briloff (2001) then produced his own study to support this claim.
He emphasized that the company with the highest total revenue almost equaled the total
revenues of the remaining 98 companies. He concluded that the sampling approach
created a “distorted image of the corporate enterprises in our ?nancial reporting
environment” (p. 126).
O’Connell (2001) supported Briloff’s claim stating that “researchers who have used
AAERs also recognize the limitations of relying on AAERs to evaluate ?nancial
statement fraud” (p. 168). He highlighted that they differ in their nature and severity
and that they are uneven in their level of disclosure. Further, O’Connell (2001) criticized
the absence of details of individual cases in its sample. He stated that “this lack of
?nancial data on sample ?rms is clearly frustrating and a major limitation of the COSO
Report” (p. 171).
O’Connell (2001) also evaluated the sampling approach of the COSO Report (1999).
He noted that one of the major conclusions of the COSO Report (1999, p. 2) is that
“companies committing ?nancial statement fraud were relatively small”. He argued
that this ?nding is only valid if one assumes AAERs are truly representative of all
?nancial statement fraud and if one assumes that the omitted ?rms are similar in
character to those 99 ?rms portrayed in the COSO Report (1999). O’Connell (2001)
observed that if one assumes both of these conditions are met then the population will
be skewed towards smaller ?rms. Moreover, when a population is skewed one way and
a random sample is taken from that population, then the resultant sample is likely to
re?ect that particular distribution shape (in this case, a plethora of small ?rms and not
too many large ones).
O’Connell (2001) concluded that such a sampling outcome is of great concern in this
case as it is the high-pro?le cases of ?nancial statement fraud that make the front
pages of the Wall Street Journal and that if one is concerned about restoring public
faith in the accounting profession, then one must study and enhance understanding of
what drives these high-pro?le cases. To enhance the usefulness of the COSO study, he
advocated a sampling approach that includes large, high-pro?le cases.
Financial
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2.4 The SEC and institutional theory
Any study that utilizes AAERs as a primary data source cannot drawconclusions from
themwithout ?rst considering the institutional environment in which these enforcement
releases are issued. Accordingly, we will draw on institutional theory to inform our
analysis.
Institutional theory, according to Scott (1987) and DiMaggio and Powell (1983, p. 53),
proposes that many aspects of formal organizational structures, policies and
procedures result from prevailing societal attitudes and the views of important
constituents. Organizations obey these rules and requirements, not just on ef?ciency
grounds, but also to enhance their legitimacy, resources and survival capacities
(Kondra and Hinings, 1998). Institutional pressures operate in conjunction with other
forces such as competition to effect ecological dynamics. Organizational behaviour is
inextricably ingrained in a vibrant system of interrelated economic, institutional and
ecological in?uences (DiMaggio and Powell, 1983).
Researchers have noted that there are some striking similarities between
institutional theory and so-called “legitimacy theory”. Legitimacy theory assumes
that businesses are bound by the social contract in which they agree to perform various
socially desired actions in return for approval of their objectives and other rewards,
and this ultimately guarantees their continued existence (Guthrie and Parker, 1989).
This de?nition has clear similarities with what we have already stated about
institutional theory. Deegan (2002, p. 293), when describing institutional theory, noted:
Re?ecting the overlapping nature of many theories, the notion of legitimacy is also central to
institutional theory [. . .] Under this [latter] theory, organisations will change their structure or
operations to conform with external expectations about what forms or structures are
acceptable (legitimate).
Deegan (2002, p. 294) makes the following further observation:
However, in contrast to legitimacy theory, wherein there is perceived to be an ability of
managers to alter perceptions of legitimacy (perhaps through disclosures), under institutional
theory managers are expected to conform with norms that are largely imposed upon them.
Of relevance to the present study, Bealing et al. (1996) utilised institutional theory to
examine the historical development of the SEC and, in particular, the form, content and
rhetoric of its early regulatory actions as a case example of an organization attempting
to justify its existence and role in the ?nancial markets. They found:
[. . .] that in order for the SEC as an organization to become legitimated [. . .] as part of the
regulatory arena, it had to take part in building up [. . .] a framework of social control applied
to the accounting profession as well as reporting entities (p. 335).
Bealing et al. (1996) found that the SEC’s legitimacy was considerably enhanced when
it began issuing enforcement releases. They concluded that by clearly stating the
appropriate audit and accounting procedures that should have been in place but were
not, the SEC established itself as an exemplar “of professional service within public
accounting” and that it was able to protect the investing public through ensuring “full
and fair disclosure to investors of all material facts” (p. 335).
Using institutional theory, it would seem that following the considerable fallout
from the Enron and WorldCom accounting scandals of the early part of this decade, the
SEC would sharpen its focus in pursuing ?nancial statement and accounting fraud.
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Certainly, the pronouncements of politicians (Bush, 2002a, b, c) and the passage of the
Sarbanes-Oxley Act of 2002 re?ect the prevailing environment for major reform of
corporate regulation and a tougher stand generally on unscrupulous behavior by
corporate executives. In such an environment, the SEC would not be immune from
pressure to increase the rate and intensity of its surveillance of company reporting.
This pressure is likely to manifest itself in the AAERs issued post-2001.
3. Research hypotheses and propositions
As noted earlier, a major objective of this study is to identify what key characteristics,
if any, of the AAERs have changed post the period covered by the COSO Report (1999).
We examine whether the changed institutional environment following the accounting
scandals may have impacted on the level of AAERs issuance, the size of companies
subject to AAERS and the nature of the allegations. The following two hypotheses and
four propositions have been developed for this purpose:
H1. There has been an increase in the issuance of AAERs by the SEC in the period
after 2001, that is, post the US accounting scandals.
This H1 is based on the hostile environment faced by the SEC and other regulators in
the wake of Enron, WorldCom and other accounting scandals (Rockness and Rockness,
2005; Bush, 2002a, b, c). Using institutional theory, one would expect to see the SEC
react to this changed environment by actively seeking out new cases of possible fraud
or risk losing its institutional legitimacy (Kondra and Hinings, 1998). Notwithstanding
any possible legitimacy concerns, the post-Enron fallout may act as a signal to the SEC
that its surveillance activities needed to be boosted:
H2. There has beenanincrease inthe size of companies subject toissuance of AAERs
by the SEC in the period after 2001, that is, post the US accounting scandals.
This H2 re?ects the “high pro?le” nature of the major accounting scandals. The COSO
Report (1999) concluded that the vast majority of frauds in its sample involved small
companies. Consistent with institutional theory, one would expect to see that following
the accounting scandals of 2001, the SECwould aggressively pursue “high pro?le” cases
and trumpet any prosecutions as vindication of its pivotal role in ensuring reliable
?nancial disclosures to investors. As noted by de Fond and Smith (1991, p. 144) “the SEC
Enforcement Division chooses cases that enhance its stature as an effective law
enforcement agency”. It follows that larger companies are likely to have been subject to
AAERS since 2001. It may also be plausible that the Enron fallout alerted the SEC to
potentially greater instances of fraud in large companies. It follows that the SEC’s
enforcement activities of larger entities may have increased for this reason post-Enron.
Examples of this increasingly aggressive approach toward “high pro?le” cases are
found in SEC press releases from 2002 onwards. For example, in a 2002 press release
relating to SEC investigations concerning the well publicised case of Tyco
International (SEC, 2002, 2003), the SEC Director of Enforcement is quoted as follows:
This enforcement action is the latest chapter in the Commission’s ongoing investigation,
together with the Manhattan District Attorney, of corruption and self-dealing at the highest
levels of Tyco management [. . .] The Commission today, together with the criminal
authorities, serves notice that misconduct by outside directors, as well as by company
management, will not be countenanced (SEC Press Release Number 2002-177).
Financial
statement fraud
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Similarly, an SEC Press Release in 2003 relating to another well publicized fraud,
Vivendi Universal, included the following quote from the Deputy Director of the
Commission’s Division of Enforcement:
This case shows the Commission’s ongoing commitment to enforcing the disclosure
obligations of issuers and it shows our successful use of a new enforcement tool provided by
the Sarbanes-Oxley Act (SEC Press Release Number 2003-184).
The following four research propositions are directly derived from the ?ndings of the
COSO Report (1999). Speci?cally, that report found that many companies committing
the fraud were experiencing net losses or were in close to break-even situations; most
frauds were not isolated to a single ?scal period and large relative to the company size;
the frauds tended to involve improper revenue recognition or overstatement of assets;
and, very senior executives were frequently involved (pp. 5-6):
P1. Companies subject to issuance of AAERs by the SEC are likely to exhibit poor
?nancial condition in the period leading up to the period of alleged accounting
fraud.
P2. The alleged accounting frauds pertaining to companies subject to issuance of
AAERs by the SEC are likely to have occurred over multiple periods and to
involve large amounts relative to the company size.
P3. The alleged accounting frauds pertaining to companies subject to issuance of
AAERs by the SEC are likely to involve improper revenue recognition or
overstatement of assets.
P4. The alleged accounting frauds pertaining to companies subject to issuance of
AAERs by the SEC are likely to have been orchestrated by the most senior
executives of companies, that is, the CEO and the chief ?nancial of?cer (CFO).
4. Research methodology
The present investigators commenced the study by identifying those AAERs that
involved an alleged breach of Rule 10(b)-5 of the US Securities Exchange Act 1934 or
Section 17(a) of the US Securities Act of 1933 or other federal anti-fraud statutes. These
are the sections that represent the primary US antifraud provisions relating to ?nancial
reporting. Excluded from the analysis were restatements of ?nancial reports due to
errors or any activities that did not result in a violation of federal anti-fraud statutes.
This approach was consistent with that of the COSO Report (1999).
The present investigators reviewed 870 AAERs for the four-year period between
January 2002 and December 2005. The search identi?ed 350 AAERs that related to
fraudulent ?nancial reporting between 2002 and 2005 (a period deliberately chosen to
re?ect the post-Enron fallout). However, there were multiple AAERs for some cases
amongst the 350 identi?ed. Where there were multiple AAERs relating to one
company, these were counted as one[1]. This reduced the number of companies to 330.
A random sample of 55 was taken from this group of companies which compares to a
?nal sample of 99 cases for the COSO Report. The Appendix lists each of the 55 cases
used in our sample together with key characteristics of each case[2]. Figure 1 shows a
comparison of the sampling approach used in the present study to that of the COSO
Report (1999).
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In addition to a random sample of all AAERs for the study period, the present study
has adopted the recommendation of O’Connell (2001) in using a sampling approach
which deliberately adds ?ve large “high pro?le” cases of ?nancial statement fraud. The
?ve cases examined are Waste Management, Qwest Communication, Tyco
International, HealthSouth Corporation and Adelphia Communications. These ?ve
cases were widely reported in the media at the time.
This approach avoids the sampling problem of the COSO Report (1999) which led
Briloff (2001, p. 126) to conclude that it was not representative of the “really stinking
stuff which is contaminating the accounting and ?nancial reporting environment”.
As a consequence, of this sampling approach, high-pro?le companies make up
8.3 per cent of the total sample. None of these cases were duplicated in the random
sample. A detailed analysis of the “high pro?le cases” is found later in this paper.
It should be noted that we deliberately did not include Enron and WorldCom in the
sample as we felt that these scandals had already been subject to a considerable
amount of prior research and analysis (Benston and Hartgraves, 2002; O’Connell, 2004).
Accordingly, we think that the facts and circumstances of these two cases are quite
well understood.
There are six key characteristics of AAERs that were speci?cally examined in this
study. All of these six were also studied in the COSO Report (1999): the size of the
company committing the alleged ?nancial statement fraud; the ?nancial condition of
Figure 1.
AAER sample selection
process for present
investigation versus
COSO Report (1999)
COSO report (1999)
(as cited in O’Connell, 2001: 170)
Present study
Approximately 800
AAERs issued in
periods 1987-97
300 firms involved in
"Financial Statement
Fraud"
220 Cases "randomly
selected" from 300
firms
204 cases remain after
16 more cases are
removed "due to data
limitations"
99 cases only where
researchers were able
to obtain "last clean
financial statement"
Approximately 870
AAERs issued in
period 2002-2005
55 Cases
"randomly selected"
from 330 items and
used in the study
Approx 330 firms
involved in "Financial
statement" fraud
5 "High profile" cases
selected and added
to study
Total cases in study 60
Financial
statement fraud
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the company in the period prior to the alleged fraud; which senior executives were
involved in the alleged fraud; the cumulative amount of alleged fraud compared to the
size of the company; whether the alleged fraud covered more than one ?scal period;
and, the typical ?nancial statement fraud techniques involved.
In addition to this analysis of AAERs, we conducted a qualitative content analysis of
the AAERs to ascertain common key motives behind the ?nancial statement frauds.
This latter analysis we believe adds considerably to the richness of our understanding of
the factors behind these phenomena and was not undertaken in the COSOReport (1999).
5. Results and discussion
5.1 SEC issuance of AAERS
Our ?ndings support H1 which proposes that there has been an increase in the
issuance of AAERs by the SEC in the period after 2001, that is, post the US accounting
scandals. The COSO Report (1999) utilised all AAERS issued between January 1987
and December 1997. The authors of that report stated the following:
We read over 800 AAERs, beginning with AAER No. 123 and ending with AAER No. 1004.
From this process, we identi?ed nearly 300 companies involved in alleged instances
of fraudulent ?nancial reporting (p. 12).
The ?nal sample of the COSOReport was then randomly selected fromthat group of 300.
If we compare these ?gures to those of the present investigation, there has been a marked
increase inissuance of AAERs inrecent years. Our analysis reveals that over the four-year
period between 2002 and 2005, a total of 871 AAERs were issued. The breakdown is as
follows: 212 in 2002, 239 in 2003, 220 in 2004 and 200 in 2005. When we identi?ed which of
these AAERs alleged fraud violations related to Rule 10(b)-5 of the 1934 Securities
Exchange Act or Section 17(a) of the 1933 Securities Act, a direct comparison with the
COSO Report approach, we found that 351 had been issued during the study period. The
split is as follows: 95 in 2002, 121 in 2003, 68 in 2004 and 67 in 2005[3].
It follows that the SEC issued AAERs at a far higher rate in the period 2002-2005
when compared to 1987-1997. In just a four-year period almost as many AAERs were
issued as for the entire 11-year period studied by the COSO Report (1999). Furthermore,
those AAERs that speci?cally related to ?nancial statement fraud appeared to
have risen substantially since the 1990s. It should also be noted that many of these
were issued in the period immediately after the scandals, i.e. 2002 and 2003.
These ?ndings could be explained by two possibilities. First, the SEC seeking to
legitimize itself to stakeholders through a greater focus on possible fraudulent ?nancial
reporting. While the SEC did receive an injection of funding from 2002 onwards to
combat corporate fraud (Bush, 2002b) the prevailing climate in the US following the
accounting scandals of 2000-2001 meant that the SEC needed to be seen to be vigilant
in this area. They may have acted as predicted by institutional theory. A second
possible explanation is that the SEC stepped up its enforcement activities post-Enron
following a realization that ?nancial statement fraud was more prevalent than
previously envisaged.
5.2 Size of companies committing ?nancial fraud
A company size (total assets and revenue) comparisons between the COSO Report
(1999) and the present study are shown in Table I.
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Financial
statement fraud
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The COSOReport (1999, p. 5) stated that the “companies committing ?nancial statement
fraud were relatively small” and that “most of the sample companies ranged well below
$100 million in total assets”. As depicted in Table I, the COSOReport (1999) found mean
total assets of companies subject to AAERs were $533 million (median of $15.7 million).
This compares with $3.3 billion (median of $187 million) for the present study. Note that
these numbers do not include the ?ve high-pro?le cases discussed later in this study.
The above ?gures represent a 522 per cent increase in the mean total assets and a 1,092
per cent rise in the median. Turning to total revenues, the COSOReport (1999) portrayed
a mean of $233 million (median of $13 million). This compares with the present study’s
equivalents of $3.1 billion and $62.6 million, respectively. These ?gures depict a 1,232
per cent increase in the mean total revenue and a 380 per cent rise in the median.
It should be noted that we did not conduct statistical comparisons of the two groups
(present study sample versus COSOReport sample) relating to company size because the
authors of the COSOReport (1999) didnot identifywhichspeci?c AAERs were includedin
their analysis[4]. Their report provided only aggregated ?ndings and hence a valid
statistical comparison such as a x
2
-test is impossible. Standard deviations are also not
reported because our sample (together with that of the COSO Report, 1999) is heavily
positivelyskewed. Reliance ona standarddeviationwouldbe misleadinginsucha skewed
distributionandconsequently, medianandquartile results are providedinsteadto provide
a more meaningful picture of the empirical data (Tabachnick and Fidell, 2001).
Clearly, the companies within the COSO Report (1999) sample are considerably
smaller, on average, than those in the present study regardless of whether the samples
are compared on the basis of their means, medians or quartiles. Hence, H2 which states
that there has been an increase in the size of companies subject to issuance of AAERs
by the SEC in the period after 2001 is supported by our results notwithstanding the
inability to conduct a statistical comparison as noted in the previous paragraph.
There are several possible conclusions that can be drawn from these ?ndings. First,
that the COSO Report (1999) sampling approach was skewed towards smaller
companies. However, this seems unlikely as the COSO Report (1999) claims to have
randomly selected its sample so this would suggest that it was representative of the
population of the time. Second, that the SEC deliberately selected larger, more “high
pro?le” companies post-2001 for prosecution consistent with an institutional theory
argument or because they came to the realization that ?nancial statement fraud was
more prevalent in large companies than previously thought. This may be quite
plausible in light of the evidence presented here and the pronouncements of the SEC
mentioned earlier. Third, that the frauds committed post-1998 were generally much
larger than pre-1998. This would seem unlikely. Fourth, potential frauds were less
likely to be detected and/or prevented prior to 2001 and were less likely to be
prosecuted by the SEC especially where larger companies were concerned. Again, this
would seem improbable.
5.3 Pro?tability of companies committing ?nancial fraud
Consistent with the COSO Report (1999), we examined the net income for the year prior
to commencement of the fraud. Our ?ndings are displayed in Table II and show a far
higher net income ?gure for our sample (mean of $48.3 million and median of $1.8
million) when compared to the COSO Report (mean of $8.6 million and median of
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$175,000). This represents a 463 per cent increase in the mean and a 929 per cent
increase in the median[5].
These ?ndings contrast somewhat with the COSO Report (1999, p. 5) which
concluded that “pressures of ?nancial strain or distress may have provided incentives
for fraudulent activities for some fraud companies”. Companies in the present
investigation were generally pro?table in the lead up period to the fraud so the
incentive to commit fraud appears to have come from other factors. In fact, only 14 out
of 55 of our sample (25.5 per cent) reported a loss in the period immediately prior to the
alleged fraud. These ?ndings do not support proposition one which stated that
companies subject to issuance of AAERs by the SEC are likely to exhibit poor ?nancial
condition in the period leading up to the period of alleged accounting fraud.
Our qualitative analysis of AAERs provided valuable insights into why executives
in the sample resorted to ?nancial statement fraud despite many of the sample being
quite pro?table entities. It is apparent that pressure to achieve Wall Street analysts’
pro?t forecasts was a recurring theme at the heart of many of these frauds and was
commonly mentioned in the AAERs:
RSA stated that it had achieved analysts’ earnings expectations for the ?rst quarter of 2001
[. . .] without the accounting change [a new, aggressive method of recognizing sales for
shipments to distributors] RSA would have failed to meet analysts’ earnings expectations by
approximately $0.02 per share or 12.5 %, and its operating income would have been 17.3 %
lower (AAER No. 1817, RSA Security, 23 July 2003).
In the Spring of 1999, Miller [former CEO] devised and implemented a scheme to fraudulently
overstate the company’s net income to meet analysts’ expectations. Pursuant to the plan, the
company fraudulently reclassi?ed rent and salary expenses that Master Graphics had already
paid to its division presidents in the ?rst quarter to assets on the company’s balance sheet thus
reducing expenses and increasing income (AAER No. 2035, Master Graphics, 14 June 2004).
5.4 Stockholders’ equity (de?cit) of companies committing ?nancial fraud
Our analysis of stockholders’ equity in the period preceding the ?nancial fraud reveals a
similar picture to that of the pro?tabilityanalysis. As shown inTable III, the COSOReport
(1999) reported a mean stockholders’ equity of $86.1 million (median of $5 million).
Our investigation shows a mean stockholders’ equity of $735.1 million (median of $58.2
million). These ?ndings re?ect a 753 per cent higher mean and a 1,062 per cent larger
median for the sample in the present study. Again, P1 is not supported by these ?ndings.
Net income/loss (in $ 000’s)
COSO Report (1999) This study
n ¼ 99 n ¼ 55 Percentage of change
Mean 8,573 48,274 463.1
Median 175 1,802 929.7
Minimum value (37,286) (879,555)
First quartile (448) (1,678) 274.6
Third quartile 2,164 45,678 2,010.1
Maximum value 329,000 1,206,000
Note: Figures were taken from the last ?nancial statement prior to fraud
Table II.
Net income for sample
?rms in the COSO Report
(1999) and the present
study
Financial
statement fraud
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5.5 Executives named in the AAERs
Table IV depicts that there is a marked difference in the results obtained in the present
study and those found in the COSO Report (1999). The COSO Report (1999) found that
the CEO (141 companies or 72 per cent of the sample) was the highest ranking
executive involved in most fraud cases[6]. In the present investigation, the senior
executive most frequently named was the CFO (33 companies representing 60 per cent
of the sample). There also seems to be a greater spread of individuals cited in this
study. The controller (13 per cent of sample), chief operating of?cer (COO) (16 per cent)
and other vice president positions (20 per cent) were commonly mentioned in the
AAERs. However, it should be noted that the companies in our sample are, on average,
much larger than that of the COSO Report (1999). Hence, this greater spread of accused
may simply re?ect the greater size and complexity of the companies in our study. Our
?ndings generally support proposition four which states that the frauds are likely to
have been orchestrated by the most senior executives of companies, that is, the CEO
and the CFO. As Table IV shows this is clearly the situation in most cases.
Our qualitative analysis of AAERs offers important insights into the direct
involvement of unscrupulous senior executives in many of the frauds:
Stockholders’ equity (de?cit) (in $ 000’s)
COSO Report (1999) This study
n ¼ 99 n ¼ 55 Percentage of change
Mean 86,107 735,084 753.7
Median 5,012 58,237 1,062.0
Minimum value (4,516) (467,706)
First quartile 1,236 7,838 534.1
Third quartile 17,037 230,030 1,250.2
Maximum value 2,772,000 12,785,239
Note: Figures were taken from the last ?nancial statement prior to fraud
Table III.
Stockholders’ equity
(de?cit) for sample ?rms
in the COSO Report
(1999) and the
present study
Types and frequencies of individuals named
COSO Report (1999) This study
No. of
companies
Percentage of fraud
cases
No. of
companies
Percentage
of fraud cases
Chief executive of?cer 141 72 26 47
Chief ?nancial of?cer 84 43 33 60
Controller 41 21 7 13
Chief operating of?cer 13 7 9 16
Chief accounting of?cer 0 0 3 5
Other vice president positions 35 18 11 20
Board of directors 21 11 6 11
Lower level personnel 19 10 1 2
Outsiders (e.g. auditors and
customers) 74 38 1 2
No title given 30 15 1 2
Other titles 24 12 6 11
Table IV.
Types and frequencies of
individual executive
positions named in
AAERs for sample ?rms
in the COSO Report
(1999) and the
present study
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Signal Tech’s former management created a corporate atmosphere which encouraged
managers to engage in improper accounting in an effort to improve Signal Tech’s bottom line.
Signal Tech’s former chairman and other senior of?cers expressed scorn for accounting
principles. [. . .] As a result of the pressure for pro?ts at all costs and disdain for accounting
principles by former senior of?cers [. . .] Keltec’s controller knowingly allowed improper
accounting practices [. . .] Moreover, Signal Tech’s senior of?cers personally directed speci?c
improper accounting practices and dictated misleading entries to be made on Keltec’s books to
overstate revenue and understate costs (AAER No. 1534, Signal Technology, 27 March 2002).
During the ?rst and second quarters of 2000, the CFO placed substantial pressure on the
Controller to continue to meet analysts’ earnings expectations in reported results. As a result
of that pressure, the Controller intentionally failed to record certain operating expenses which
were material to both quarters (AAER No. 1691, Mercator Software, 16 December 2002).
5.6 Cumulative dollar amount of fraud for a company
As shown in Table V the average fraud amount in our sample involved $137 million of
cumulative misstatement or misappropriation (median of $10.8 million)[7]. This is much
higher than those found in the COSOReport (1999) where a mean and median of $25 and
$4.1 million, respectively, were reported. This comparison indicates a 448 per cent
increase in the mean size of the fraud and a 163 per cent rise in the median. Moreover, the
cumulative amounts of the fraud were quite high relative to the size of the company. The
median fraud of $4.1 million for the COSO Report (1999) sample represented 25 per cent
of median total assets ($15.7 million). In our sample, the median fraud of $10.8 million
represented 6 per cent of median total assets ($186.9 million). In both samples, the
median fraud amount considerably exceeded the median net income. It follows that P4 is
supported as the frauds do, on average, involve large amounts relative to company size.
Qualitative analysis of the AAERs shows a recurring theme that the SEC contended
that a key motivation of executives to manipulate reported earnings was that these
actions were likely to have a signi?cant impact on the share price and associated
bonuses of executives. While such a contention cannot be proven without conducting
interviews of executives under investigation, the tone of AAERs strongly indicate this
motive may have been a signi?cant factor in the frauds:
The compliant alleges that Gless [former CFO] and other Peregrine senior of?cers engaged in
deceptive practices to arti?cially in?ate Peregrine’s revenue and stock price, and that Gless
then took fraudulent action to conceal the scheme (AAER No. 1759, Peregrine Systems,
16 April 2003).
Cumulative fraud amount (in $ 000’s)
COSO Report (1999) This study
n ¼ 99 n ¼ 55 Percentage of change
Mean 25.0 137.0 448.0
Median 4.1 10.8 163.4
First Quartile 1.6 million 3.95 million 146.9
Third Quartile 11.76 million 53.6 million 355.8
Smallest Fraud 20 50 150
Largest Fraud 910,000 3,000,000 229.7
Note: Figures were taken from AAERs
Table V.
Cumulative fraud amount
for sample ?rms in the
COSO Report (1999) and
the present study
Financial
statement fraud
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In 2001 and 2002 Huntington reported in?ated earnings in its ?nancial statements, enabling
Huntington to meet or exceed Wall Street analyst earnings per share expectations and
internal EPS targets that determined bonuses for senior management (AAER No. 2251,
Huntington Bancshares, 2 June 2005).
5.7 Length of fraud period
The COSO Report (1999, p. 30) found that the average fraud was for two years with a
median of 21 months. Table VI indicates that 36 per cent of frauds in the current study
related to one year or less with 36 per cent between one and two years, and 18 per cent
lasting for three years. In all, 64 per cent of all frauds in our sample were for greater
than one year. These results are consistent with P2 in indicating that many frauds
occur across multiple periods.
5.8 Common ?nancial fraud techniques
As can be seen in Table VII, by far the most common technique used to fraudulently
misstate ?nancial statement information in our sample involved deliberate
overstatement of revenue. In fact, 96 per cent of alleged fraud involved this method.
In the COSO Report (1999), 50 per cent of the sample employed this method suggesting
either the SEC has deliberately increased its surveillance activities in this area or that
this type of fraud has become far more prevalent since the 1990s. The second most
common technique to fraudulently misstate ?nancial statement information was the
overstatement of assets (53 per cent). However, the use overstatement of assets and
understatement of expenses/liabilities have remained relatively consistent across the
two periods. Misappropriation of assets has declined somewhat across the two periods
(down from 40 per cent in the COSO Report to 11 per cent in the present study). The
above ?ndings support P3 in that the sample frauds commonly involved improper
revenue recognition or overstatement of assets.
Our qualitative analysis of AAERs provided detailed descriptions of the types of
techniques employed by executives to misrepresent the company’s ?nancial
performance. The deliberate overstatement of revenue stands out as the preferred
option for accounting fraud:
[Senior executives] falsely reported millions of dollars of non-existent sales, including sales to
a ?ctitious customer, and used other fraudulent techniques to in?ate Anicom’s revenues’
(AAER No. 1554, Anicom, 6 May 2002).
During the period from January 1996 through June 1998, Signal Tech’s Keltec division
prematurely recognized revenue, failed to record contract losses and failed to write down
Financial periods (years) covered by fraud Number of sample Percentage of total sample
One year 20 36
Two years 20 36
Three years 10 18
Four years 2 4
Five years 3 6
Notes: Figures were taken from AAERs, n ¼ 55 companies; the COSO Report (1999) did not provide
data on this variable broken down as above; however, the COSO Report (1999, p. 30) reports that
14 per cent of the frauds were for one year or less with an average period of approximately two years
Table VI.
number of ?nancial
periods (years) covered
by fraud for sample ?rms
in the present study
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excess inventory. Signal Tech’s former Chairman and CEO, former CFO, and other former
senior corporate of?cers, knew of and in multiple instances personally directed improper
accounting practices. On several occasions the former chairman and other senior of?cers even
dictated speci?c misleading entries to be made on Keltec’s books (AAER No. 1534, Signal
Technology, 16 December 2002).
6. Analysis of ?ve high-pro?le companies
Two of the main criticisms of the COSO Report (1999) by Briloff (2001) and O’Connell
(2001) are a paucity of “high pro?le” cases in that sample and the lack of disclosure of
the speci?c AAERs scrutinized by those investigators. In contrast, the present study
provides details of all AAERs examined (see the Appendix) and uses a sampling
approach that speci?cally includes an analysis of ?ve high-pro?le cases during the
study period. The ?ve frauds examined are Waste Management, Qwest
Communication, Tyco International, HealthSouth Corporation and Adelphia
Communications. They are considered to be high pro?le in the sense that they were
widely cited in the media as examples of fraud.
Table VIII displays a summary of the key characteristics of the ?ve major frauds.
Table VIII shows that these ?ve companies were large varying from a minimum of
$1.6 billion in total assets through to a maximum of $8.1 billion (mean of $4.6 billion).
The accumulated amount of the frauds was also sizeable varying from a minimum of
$567 million through to a maximumof $3.5 billion (mean of $1.9 billion). It should also be
noted that these fraud amounts were signi?cant when compared to each company’s
revenue or pro?t situation. For example, in60 per cent of the cases the accumulated fraud
COSO Report (1999) Present study
Percentage of sample using
fraud method
Percentage of sample using
fraud method
Methods used to misstate ?nancial
statements
Sub-
category (%)
Overall
category (%)
Sub-
category (%)
Overall
category (%)
Improper revenue recognition 50 96
Recording ?ctitious revenues 26 36
Recording revenues prematurely 24 36
No description/overstated 16 23
Overstatement of assets (excluding
accounts receivable overstatements
due to revenue fraud)
50 53
Overstating existing assets 37 35
Recording ?ctitious assets or assets
not owned
12 7
Capitalizing items that should be
expenses
6 11
Understatement of expenses/liabilities 18 24
Misappropriation of assets and other
miscellaneous techniques
40 11
Notes: Figures were taken from AAERs; COSO Report (1999) n ¼ 204; present study n ¼ 55;
subcategories such as “Recording ?ctitious revenues” and “Capitalizing expenses” do not sum to the
overall category totals due to multiple types of fraud involved at a single company, so, for example,
a company could have recorded revenues both ?ctitiously and recorded prematurely
Table VII.
Common ?nancial
statement fraud
techniques used by
sample ?rms in the COSO
Report (1999) and the
present study
Financial
statement fraud
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Table VIII.
Summary of key
characteristics of ?ve
major frauds during the
study period
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amount exceeded the company’s total revenue from the previous year’s ?nancial result.
In all cases, the frauds covered several reporting periods with a minimum of four years
and a maximumof 7.5 years (mean of 5.5 years). The CEOwas implicated in the fraud in
all cases with the CFO prosecuted in 80 per cent of them. In 40 per cent of the cases, the
company was quite pro?table in the year preceding the fraud (as measured by net
income). In another 40 per cent, the company reported a large loss the previous year and
in the remaining case the company reported a small loss. Arti?cial in?ation of reported
earnings was at the centre of the prosecution in all but one of the cases.
Our qualitative analyses of the AAERs show that an inappropriate “tone at the top”
was a key issue in most of these cases:
The business unit executives made it clear that subordinates had to meet or exceed these
aggressive earnings targets at all costs (AAER No. 2209, Qwest Communications
International, issued 15 March, 2005).
Senior of?cers of the Company would, on a quarterly basis present the CEO with an analysis
of the company’s actual but, as yet, unreported earnings for the quarter as compared to Wall
Street’s expected earnings for the Company. If the actual ?nancial results of HealthSouth fell
short of analyst expectations, the CEO would tell his executives to “?x it” by recording false
earnings on HRC’s accounting records to make up the shortfall.
Treating company funds as though they were entitlements of senior executives was
another theme:
The SEC charged that Adelphia, at the direction of the individual defendants [. . .] concealed
rampant self-dealing by the Rigas Family, including the undisclosed use of corporate funds
for Rigas family stock purchases and the acquisition of luxury condominiums in New York
and elsewhere (AAER No. 1599, Adelphia).
This is a looting case [. . .] it involves egregious, self-serving and clandestine misconduct by the
three most senior executives at Tyco (AAERNo. 1839, Tyco International, issuedAugust 13, 2003).
The ubiquitous issue of pressure to appease analysts’ forecasts also was a common
theme:
The complaint was that these eight of?cers arti?cially accelerated Qwest’s recognition of
revenue in two equipment sale transactions for its Global Business Markets Unit It is alleged
that that when the Qwest ?nancial management indicated the company would miss its
quarterly targets, the Global Business Markets of?cers would bridge the gap by fraudulently
mischaracterizing these transactions (AAER No. 1726, Qwest Communications, issued
February 25, 2003).
Common approaches to perpetrating the accounting fraud were revenue and expense
manipulation:
To summarize the charges of improper accounting practices, the defendants “resorted to
improperly eliminating and deferring current period expenses to in?ate earnings.” Such
practices included: avoiding depreciation expenses on their garbage trucks; assigning
arbitrary salvage values to other assets that previously had no salvage value; failing to record
expenses for decreases in the value of land?lls as they were ?lled with waste; refusing to
record expenses necessary to write off the costs of unsuccessful and abandoned land?ll
development projects; establishing in?ated environmental reserves (liabilities) in connection
with acquisitions so that the excess reserves could be used to avoid recording unrelated
operating expenses; improperly capitalizing a variety of expenses; and, failing to establish
Financial
statement fraud
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suf?cient reserves (liabilities) to pay for income taxes and other expenses (AAER No. 2116,
Waste Management).
The entries designed to perpetrate the fraud primarily consisted of reducing a contra revenue
account called “contractual adjustment” and/or decreasing expenses (either of which
increased earnings) and correspondingly increasing assets or decreasing liabilities (AAER
No. 1744, HealthSouth Corporation).
In summary, the ?ndings from these ?ve high-pro?le cases largely support those of the
55 randomly selected cases. The extent and nature of the frauds was signi?cant and
the companies involved were substantial in size with senior executives treating the
company’s funds as if they were their own.
7. Conclusion
This study set out to examine the US SEC’s investigations into ?nancial statement
fraud through an analysis of AAERs from 2002 to 2005. Findings were compared to the
COSO Report which examined AAERs from 1987 to 1997. Using an institutional theory
framework it was hypothesized that the post-Enron environment may have brought
about changes in the activities of the SEC in an effort for this agency to legitimize itself
before major stakeholders. Our study did ?nd evidence of changes when compared to
the COSO Report (1999). Speci?cally, we found that there far more AAERs issued
post-Enron and the companies involved were, on average, much larger, more pro?table
and the frauds more substantial than those exhibited in the COSO Report (1999). These
?ndings hold even before considering the additional ?ve high-pro?le cases that we
added to accommodate the recommendation of Briloff (2001). Our results suggest that
the SEC became more aggressive at pursuing larger companies for ?nancial statement
fraud in the post-Enron environment than perhaps was the case in the 1990s.
Our study has also addressed a major criticism of the COSO Report (1999) by Briloff
(2001) and O’Connell (2001), namely, that there were an insuf?cient number of “high
pro?le” companies included in the sample of the COSO Report (1999). We believe that
the addition of case studies on ?ve major accounting frauds to 55 randomly selected
cases addresses those criticisms of the COSO Report (1999).
There are several important implications of this research. First, while the COSO
Report (1999, p. 5) concluded companies committing ?nancial statement fraud tend to
be small this certainly does not appear to be the case based on our more recent sample.
In fact, it would seem that accounting frauds often involve large companies with the
most senior executives implicated. These frauds often cross several reporting periods.
A second key implication is that, rather than being motivated to hide losses, the
frauds appear to be a mechanism for boosting reported earnings to appease Wall Street
analysts. The motivation for this appears to be ensuring a rising stock price and thus
increased executive remuneration. This evidence from the AAERs would seem to show
that devices designed to reduce agency costs such as stock options have provided a
perverse incentive for some executives to do whatever it takes, including fraud, to
boost the stock price in the short-term. A third implication is that improper revenue
recognition through recording ?ctitious revenues or recording revenues prematurely
continues to be the preferred methods for deception. Auditors and analysts alike need
to remain vigilant in searching for any signs of such reprehensible actions by
management.
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Many of these ?ndings appear to be highly relevant in considering the incidence of
?nancial statement fraud globally. Securities markets regulators, auditors and
?nancial analysts to name a few would bene?t from consideration of these ?ndings.
There are some limitations to the present study that should be recognized. First,
AAERs tend to be uneven in their level of disclosure and format thus making some more
useful for analysis purposes than others. It is apparent from both the COSO Report
(1999), and the present study, that to enhance the usefulness of AAERs for analysis
purposes, the SEC needs to improve their comparability in relation to language,
structure and content. Second, there is a possibility of selection bias by relying on
AAERs as the primary data source for ?nancial statement fraud. This is because
AAERs mayre?ect the prevailingagenda of the SEC(Bonner et al., 1998) or differ intheir
nature or severity (Feroz et al., 1991). Notwithstanding, these limitations AAERs have
been widely applied by researchers as a reasonably objective and reliable data source for
studying fraud (de Fond and Smith, 1991; Bonner et al., 1998). Third, the observed rise in
enforcement actions and the size of ?rms prosecuted may be explained by a variety of
factors other than legitimization such as a greater awareness of the possibility of fraud
post-Enron. Fourth, if one accepts that the COSOReport (1999) possessed weaknesses in
its sampling approach then it may not be an accurate source of comparison for studying
changes in the SEC’s enforcement activities over the period. Fifth, the level of statistical
comparison of the two samples possible was limited by the unavailability of detail on the
COSO sample. However, the large differences across the two samples in descriptive
statistics such as means suggest a highly likelihood of statistically signi?cant
differences if the data were able to be analysed in this way. Certainly, the differences
between the two samples are of great practical relevance.
Avenues for future research include more case-based research into ?nancial
statement fraud using a variety of sources such as company documents, court cases,
judgments and interviews. It would also be useful to conduct interviews with
surveillance personnel of the corporate regulator to ascertain information about
prevailing enforcement agendas and processes and their speci?c impact on enforcement
activities. Industry-based comparisons may also provide interesting insights.
Notes
1. In some cases a separate AAER was issued for the company and for each individual
executive involved in the accounting fraud.
2. Briloff (2001) was highly critical of the absence from the COSO Report (1999) of such a list.
3. It should be noted that the COSO Report (1999) did not report a year-by-year dissection of
AAERs.
4. The authors contacted the authors of the COSO Report in an effort to obtain details of the
sample used by them. We were informed that due to con?dentiality requirements by the
Treadway Commission they would be unable to divulge this information.
5. We cannot discount that some of these ?rms may have practiced earnings management in
the periods leading up to the alleged ?nancial statement fraud so these ?gures may be
overstated. However, it would seem likely that the level of overstatement would be similar
across the two periods of analysis.
6. It should be noted that in determining Table IV, the highest managerial title for an
individual was used.
Financial
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7. It should be noted that on a few occasions the AAERs did not fully disclose the quantum of
dollars relating to the fraud. Accordingly, we conducted additional research through the
SEC’s Litigation Releases et al. (available at: www.sec.gov/litigation/litreleases.shtml)
to ascertain the precise fraud amount.
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fraud relate to ?ber-optic deals with other telecom ?rms”, Wall Street Journal, p. A.3,
9 May, available at: http://proquest,uni.com.elibrary.jcu.edu.au/pqdweb?index¼1&sid
¼4&srchmode¼1&v (accessed 21 June 2006).
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scandals and lessons for Australia”, Australian Accounting Review, Vol. 15 No. 2, pp. 52-67.
Perell, P.M. (2006), “Deceived with ornament: law, lawyers and Shakespeare’s The Merchant of
Venice”, available at: www.lsuc.on.ca/media/third_colloquium_paul_perell.pdf (accessed
17 January 2007).
University of California (2005), “Federal court approves dynergy securities fraud settlement”,
University of California, Oakland, CA, 8 July, Press Release, available at: www.
universityofcalifornia.edu/news/2005/jul08C.html (accessed 25 May 2006).
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About the authors
Richard Lane, MBA, CA, has had extensive years of experience in public practice including being
the Principal of his own accounting ?rm in North Queensland. In recent years, he has worked as
both a Financial Controller for an exporting company and as a Lecturer in Accounting at James
Cook University.
Brendan T. O’Connell, PhD (Monash), CPA, CMA, F Finsia, has extensive teaching and
research experience in leading Australian and US Universities including Monash University, the
University of Richmond in Virginia, Deakin University and James Cook University. He has
published numerous papers in leading academic journals such as the Journal of Accounting
Auditing and Finance, Abacus, Critical Perspectives on Accounting, Issues in Accounting
Education, the Australian Accounting Review and the Journal of Applied Finance on topics such
as earnings management, ?nancial statement fraud, business ethics and securitisation. He is also
Guest Editor of a special issue of Critical Perspectives on Accounting entitled “Enron.con” and a
special issue of Accounting History that provides an historical perspective to accounting and
audit failure within corporate collapse. He is also a member of the editorial board of the
Australian Accounting Review. His case studies on the collapses of Enron and HIH Insurance now
form part of the CPA Program in Australia. He is also a Chief Examiner for the foundation
segment of the CPA Program in Australia. Prior to working in academia, he worked in the
investment banking industry with Bankers Trust Australia, as a ?nancial analyst with the ANZ
Banking Group Ltd, and in corporate recovery with Pannell Kerr Forster. Brendan T. O’Connell
is the corresponding author and can be contacted at: [email protected]
To purchase reprints of this article please e-mail: [email protected]
Or visit our web site for further details: www.emeraldinsight.com/reprints
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Table AI.
Summary of the
accounting and auditing
enforcement releases
(AAERs) included in the
sample
Financial
statement fraud
141
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This article has been cited by:
1. Daniella Juric, Brendan O’Connell, Michaela Rankin, Jacqueline Birt. 2015. Determinants of the Severity
of Legal and Employment Consequences for CPAs Named in SEC Accounting and Auditing Enforcement
Releases. Journal of Business Ethics . [CrossRef]
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doc_662581877.pdf