June 1999 Issue

Small Companies Commit Most Financial Fraud

By Ann E. Spaulding

A recently released study found that small corporations--those with assets below $100 million--committed most of the fraud in financial reporting among public companies.

Eighty-three percent of the fraud cases involved the chief executive officer, the chief financial officer, or both. In addition, insiders and others with significant equity ownership and little experience serving on boards dominated the makeup of the companies' boards of directors.

The report, Fraudulent Financial Reporting: 1987­1997, released by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission, analyzed 200 randomly selected cases out of the 300 alleged financial frauds investigated by the Securities and Exchange Commission between 1987 and 1997.

"We now have a current profile of the frauds committed, the companies and individuals involved, and the consequences of the frauds," said John Flaherty, COSO chair and retired general auditor for PepsiCo.

The study found that typical fraud involved overstating revenues and assets. More than half of the cases involved revenues recorded prematurely or fictitiously. About half of the frauds involved overstating assets by understating allowances for receivables; overstating the value of inventory, property, plant and equipment, and other tangible assets; and recording nonexistent assets.

Issues for External Auditors

The fraud cases involved companies audited by all sizes of CPA firms, with 56 percent clients of Big Eight/Six firms.

Fifty-five percent of the reports issued in the last year of the period studied contained unqualified opinions. The remaining 45 percent departed from the standard unqualified report and addressed issues related to the auditor's substantial doubt about going concern, litigation and other uncertainties, changes in accounting principles, and changes in auditors between fiscal years. Three percent received qualified opinions due to a GAAP departure.

Just over 25 percent of the companies changed auditors during the time frame beginning with the last clean financial statement period and ending with the last fraudulent financial statement period. A majority of the auditor changes occurred during the fraudulent period.

The study stated the strong need for auditors to look beyond the financial statements to understand risks unique to the company's industry, management's motivation toward aggressive reporting, and client internal control (particularly the tone set by top management), among other matters. The report recommended that auditors consider information from a variety of sources to establish an appropriate level of professional skepticism for each engagement and recognize the potential for greater audit risk when auditing companies with weak board and audit committee governance.

As a result of the study, the SEC may broaden its recent initiative to strengthen corporate audit committees to include small companies.

COSO's goal is to prevent fraudulent financial reporting. The group is an alliance of five professional organizations--the AICPA, the American Accounting Association, the Financial Executives Institute, the Institute of Internal Auditors, and the Institute of Management Accountants.

"The report is a 'must read' for everyone involved in corporate governance, including board members, CEOs, financial executives, auditors, and regulators," Flaherty said.