COSO's New Fraud Study: What It Means for CPAs
The Committee of Sponsoring Organizations of the Treadway Commission (COSO) has just published a follow-up study to its landmark 1987 report . Fraudulent Financial Reporting: 1987-1997, An Analysis of U.S. Public Companies , examines financial reporting fraud cases the SEC has brought against U.S. public companies. Here, the authors of the study share some key findings and add their recommendations.
COSO commissioned this study to help in its efforts to combat financial statement fraud and find the answers to these questions: Who is committing fraud? What is the nature? The study examined instances of alleged fraudulent financial reporting by SEC registrants reported in SEC Accounting and Auditing Enforcement Releases (AAERs) in the 11-year period from 1987-1997. The study identified approximately 300 total frauds and specifically covers 200 randomly selected companies involved in financial statement fraud. The study identifies key company and management characteristics that could help auditors identify the warning signs.
Exhibit 1: Common Financial Statement Fraud Techniques
Who's committing the fraud?
Companies committing financial statement fraud were relatively small. The typical company had well below $100 million in total assets in the year preceding the fraud. Most companies—78% in fact—were not listed on the New York or American Stock Exchanges. And as might be expected, some companies committing fraud were experiencing net losses or were barely breaking even in the periods before the fraud. The median net income was only $175,000 in the year before the fraud—financial pressures may have provided incentives for the fraudulent activities of some companies.
Senior executives were frequently involved. In 72% of the cases, the AAERs named the CEO; in 43% they named the CFO. As for audit committees, most met about once a year—and 25% of the companies didn't have audit committees at all. Of those that did, more than half the audit committee members (65%) did not appear to be certified in accounting or have current or prior work experience in key accounting or finance positions.
The boards of directors in companies with the alleged fraudulent reporting were generally insiders and "gray" directors (outsiders with special ties to the company or management), with significant equity ownership and apparently little experience serving as directors. Collectively, the directors and officers owned nearly 33% of the companies' stock, with the CEO/president personally owning about 17%. In nearly 40% of the boards, no director had served as an outside or gray director on another company's board.
In nearly 40% of the companies, the proxy provided evidence of family relationships among the directors or officers. The founder and current CEO were the same person or the original CEO was still in place in nearly half of the companies. In more than 20% of the companies, there was evidence that officers held incompatible job functions, for example, acting as both CEO and CFO.
External auditors were also involved. In the 195 fraud cases where AAERs explicitly named individuals, auditors were named in 56 (29%)—either for alleged involvement in the fraud (30 cases) or for negligent auditing (26 cases). And problematic companies jumped around: More than 25% of the companies changed auditors from the last clean financial statement period to the last fraudulent financial statement period.
|Exhibit 2: Common Revenue Fraud Techniques |
- Sham sales. To cover up fraud, company representatives often falsified inventory records, shipping records and invoices. In some cases, a company recorded sales for goods merely shipped to another company location. In other cases, it pretended to ship goods to appear as if a sale had occurred and then hid the related inventory, which was never shipped to customers, from the auditors.
- Premature revenues before all the terms of the sale were completed. Generally this involved recording sales after the goods were ordered but before they were shipped to the customer.
- Conditional sales. These transactions were recorded as revenues even though the sales involved unresolved contingencies or the terms of the sale were amended subsequently by side letter agreements that often eliminated the customer's obligation to keep the merchandise.
- Improper cutoff of sales. To increase revenues, the accounting records were held open beyond the balance sheet date to record sales of the subsequent accounting period in the current period.
- Improper use of the percentage-of-completion method. Revenues were overstated by accelerating the estimated percentage of completion for projects in process.
- Unauthorized shipments. Revenues were overstated by shipping goods not ordered by the customer or by shipping defective products and recording revenues at full, rather than discounted, prices.
- Consignment sales. Revenues were recorded for consignment shipments or shipments of goods for customers to consider on a trial basis.
What kind of frauds?
Overall, the frauds were relatively large in amount when compared with the small size of the companies involved: The median amount of financial statement misstatement or misappropriation of assets was $4.1 million although the median amount of total company assets was only $16 million. The frauds were not one-shot deals, either: Most frauds overlapped at least two fiscal periods, frequently involving both quarterly and annual financial statements. The average fraud period extended over 23.7 months.
Typical financial statement fraud techniques involved the overstatement of revenues and assets (see exhibit 1 ). More than half the frauds involved overstating revenues by recording revenues prematurely or fictitiously. Many of the revenue frauds affected only transactions recorded right at the end of a period (see exhibit 2 ). About half the frauds also involved overstating assets by understating allowances for receivables, overstating the value of inventory, property, plant and equipment and other tangible assets, and recording assets that did not exist (see exhibit 3).
|Exhibit 3: Asset Accounts Frequently Misstated |
||Number of |
|Accounts receivable (other than revenue fraud)
|Property, plant, and equipment
|Oil, gas, and mineral reserves
Implications for CPAs
The report gives some concrete advice on what auditors can do to combat fraud.
- The relatively small size of companies' committing fraud suggests that they may be unable or even unwilling to implement cost-effective internal controls. Auditors need to challenge management to ensure that a baseline level of internal control is present.
- Given that some of the companies experienced financial strain in periods preceding the fraud, auditors need to monitor an organization's going-concern status, especially with new clients. (In fact, consideration of going concern is now required on all audits.)
- Auditors should be aware of the possible complications arising from family relationships and from individuals holding significant power or incompatible job functions.
- Because frauds so often run over many reporting periods, auditors may need to consider interim reviews of quarterly financial statements as well as the possible benefits of continuous auditing strategies.
- Auditors may need to consider and test internal controls related to transaction cutoff and asset valuation. They should design testing procedures to reduce audit risk to an acceptable level. Procedures affecting transaction cut-off, transaction terms and account valuation for end-of-period accounts and transactions may be particularly pertinent.
- Auditors need to understand risks unique to the client's industry and management's motivation towards aggressive reporting—particularly the tone at the top and client internal control. An appropriate level of professional skepticism is a requirement for each engagement.
- Companies with weak boards and audit committees present an audit challenge. Auditors should assess the substance and quality of client boards and be alert for boards dominated by insiders and others with strong ties to management or the company. Auditors also should be wary of audit committees that rarely meet or that are composed primarily of nonfinancial experts.
For further consideration
Fraud is not a one-article topic, but an ongoing problem. Those wanting further details should consult the Journal index for more articles on fraud. The Institute's Web site ( www.aicpa.org ) has an executive summary of the study, which is available in its entirety from the AICPA (product no. 990036JA) for $20 for members, $25 for nonmembers. q
—Mark S. Beasley, CPA, PhD., assistant professor, department of accounting, North Carolina State University; Joseph V. Carcello, CPA, CIA, CMA, PhD, associate professor, the department of accounting and business law, University of Tennessee; and Dana R. Hermanson, CPA, PhD, director of research of the Corporate Governance Center, associate professor of accounting, Kennesaw State University, Georgia
Running the Numbers
A s anticipation builds for the NBA playoffs that will begin this month, the specter of the 1998-99 NBA season that almost wasn't is a distant memory to many basketball fans.
"The popular witticism is that billionaire owners and millionaire players can't figure out how to divide two billion dollars," said William Hessberg, CPA and disgruntled hoop fan, of the lockout that began at the close of the 199798 season.
William Hessberg, CPA and hoop fan, analyzed Celtic financials.
(PHOTO BY: TOM SOBOLIK/BLACK STAR)
Instead of just crossing his fingers and hoping for a speedy resolution to the league's labor dispute, however, Hessberg put pencil to paper and ran some numbers while he waited for the season to begin.
Specifically, Hessberg wanted to find out whether the NBA franchises were actually producing millions in profits, where the money was coming from and where it was going. He decided to use the Boston Celtics as a case study for his analysis.
"The Boston Celtics are the best source for answers," Hessburg said. "The Celtics are a limited partnership that is traded on the NYSE (symbol BOS), and they issue an audited annual report."
Although other teams are part of publicly traded companies, he added, their numbers often are combined with other business segments and are hidden in consolidated reports.
For the year ending June 30, 1998, the Celtics' revenue was $75.7 million. The breakdown (in millions) of that revenue was as follows:
Income was 20% higher than in the previous year when the numbers were as follows:
Broadcast revenue and ticket sales were the key factors behind the improvement in Boston's financial results over the last two years, Hessberg said. The broadcast fees came from league contracts with national broadcasters (NBC and Turner Sports) and local networks.
The Celtics sold more tickets in the 199798 season than in the prior year because the team was better, Hessberg said. Boston improved its record over the year before by 21 wins.
On the expense side, operating expenses for both years were roughly the same ($62.3 million in 1997 and $61.9 million in 1998).
Players' salaries are the biggest part of operating expenses. "In the 199798 season, the Celtics paid their 17 players just under $27 million," said Hessberg. "Veteran guard Dee Brown was the highest paid Celtic at $3.5 million."
By increasing the revenue and keeping operating expenses down, Boston managed to increase income from operations to $13.8 million in 1998 from $722,519 in 1997. Not bad off-the-court action for a team that has had some success on court as well.
"The Celtics had revenues of $76 million last year. If you multiply that by 29 teams, that equals $2.2 billion dollars," Hessberg said. "With the new TV deal, total revenues for this season could get closer to $3 billion."
Let's hope the owners and players have ended their squabbling for good and can find a way to share the $3 billion NBA pie. n