The Changing Face of the US SEC’s Enforcement
 Investigations (AAERs) into Financial Statement Fraud in the
              ...
The Changing Face of the US SEC’s Enforcement
Investigations (AAERs) into Financial Statement Fraud in the
               ...
The Changing Face of the US SEC’s Enforcement
 Investigations (AAERs) into Financial Statement Fraud in the
              ...
have selected this comparison is to study whether “high profile” accounting scandals such

as Enron and WorldCom have resu...
relate to financial statement reporting. A random sample of 220 cases of financial

statement fraud were subjected to anal...
The SEC admits that its enforcement program is designed to “concentrate on

particular problems areas and to anticipate em...
O’Connell (2001) supported Briloff’s claim stating that “researchers who have

used AAERs also recognize the limitations o...
drives these high profile cases. To enhance the usefulness of the COSO study, he

advocated a sampling approach that inclu...
take part in building up…a framework of social control applied to the accounting

profession as well as reporting entities...
companies subject to AAERS and the nature of the allegations. Specifically, we test the

following six hypotheses:

      ...
alerted the SEC to potentially greater instances of fraud in large companies. It follows

that the SEC’s enforcement activ...
H3:    Companies subject to issuance of AAERs by the SEC are likely to
        exhibit poor financial condition in the per...
sample of 55 was taken from this group of companies which compares to a final sample

of 99 cases for the COSO Report. App...
O’Connell, 2004). Accordingly, we think that the facts and circumstances of these two

cases are quite well understood.

 ...
The final sample of the COSO Report was then randomly selected from that group

of 300. If we compare these figures to tho...
Size of Companies Committing Financial Fraud

        The COSO Report (1999) stated that the sample companies are relative...
is heavily positively skewed. Reliance on a standard deviation would be misleading in

such a skewed distribution and cons...
Profitability of Companies Committing Financial Fraud

       Consistent with the COSO Report (1999), we examined the net ...
forecasts was a recurring theme at the heart of many of these frauds and was commonly

mentioned in the AAERs:



       R...
Executives Named in the AAERs

           Table 5 depicts that there is a marked difference in the results obtained in the...
result of the pressure for profits at all costs and disdain for accounting
        principles by former senior officers … ...
INSERT TABLE 6 ABOUT HERE



       Qualitative analysis of the AAERs shows a recurring theme that executives

perceived t...
of revenue. In fact, 96% of alleged fraud involved this method. In the COSO Report

(1999), 50% of the sample employed thi...
accounting practices. On several occasions the former chairman and other
       senior officers even dictated specific mis...
maximum of 7.5 years (mean of 5.5 years). The CEO was implicated in the fraud in all

cases with the CFO prosecuted in 80%...
This study set out to examine the U.S. SEC’s investigations into financial

statement fraud through an analysis of AAERs f...
second key implication is that, rather than being motivated to hide losses, the frauds

appear to be a mechanism for boost...
possibility of fraud post-Enron. Fourth, if one accepts that the COSO Report (1999)

possessed weaknesses in its sampling ...
APPENDIX ONE
       SUMMARY OF THE ACCOUNTING AND AUDITING ENFORCEMENT
           RELEASES (AAERs) n=55 INCLUDED IN THE SA...
AAER   Date      Company name          Fraud Technique       Fraud       Fraud     Executives Involved
No.    Issued      ...
4                              inventory
AAER   Date      Company name         Fraud Technique        Fraud    Fraud     E...
Appendix Two
     Summary of the Facts Alleged in AAERS of Five Major
      Financial Statement Frauds during the Study Pe...
Appendix Two (cont.)

       To summarize the charges of improper accounting practices, the defendants

“resorted to impro...
Appendix Two (cont.)

       2. Qwest Communications International Inc (Qwest)

       Source: AAER No 1726 issued Februar...
Appendix Two (cont.)

       In 2003, the SEC filed civil fraud charges against eight officers and former

officers of Qwe...
Appendix Two (cont.)

        3. Tyco International Ltd (Tyco)

        Source: AAER No 1839 issued on August 13, 2003.

 ...
Appendix Two (cont.)

        4. HealthSouth Corporation

        Source: AAER no 1744 issued on March 20, 2003.

        ...
Appendix Two (cont.)
       The entries designed to perpetrate the fraud primarily consisted of reducing a

contra revenue...
Table 1: AAER Sample Selection Process for Present
        Investigation Versus COSO Report (1999)
       COSO Report (199...
Table 2: Total Assets and Revenue for Sample Firms in the
          COSO Report (1999) and the Present Study

            ...
Table 4: Stockholders’ Equity (Deficit) for Sample Firms in the
          COSO Report (1999) and the Present Study

      ...
Table 6: Cumulative Fraud Amount for Sample Firms in the
          COSO Report (1999) and the Present Study

             ...
Table 8: Common Financial Statement Fraud Techniques used
 by Sample Firms in the COSO Report (1999) and the Present
     ...
Table 9: Summary of Key Characteristics of Five Major Frauds during the Study Period
Company         Size                 ...
REFERENCES & BIBLIOGRAPHY

Bailey,J. 2000. “Waste Management Settles SEC Charges That It Misled Investors in
     Spring o...
COSO Report (Research Commissioned by the Committee of Sponsoring Organizations
   of the Threadway Commission). 1999. in ...
Securities and Exchange Commission (SEC). 1989. Fifty-fifth Annual Report of the SEC
        (Washington DC: Government Pr...
Upcoming SlideShare
Loading in...5
×

Securities and Exchange Commission (SEC). 2002. "SEC Sues ...

991

Published on

0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total Views
991
On Slideshare
0
From Embeds
0
Number of Embeds
0
Actions
Shares
0
Downloads
23
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide

Securities and Exchange Commission (SEC). 2002. "SEC Sues ...

  1. 1. The Changing Face of the US SEC’s Enforcement Investigations (AAERs) into Financial Statement Fraud in the Post-Enron Environment By Richard Lane# James Cook University Brendan T. O’Connell† James Cook University # School of Business, James Cook University, Townsville, Queensland, Australia 4811 † Professor, School of Business, James Cook University, Townsville, Queensland, Australia 4811 Corresponding Author: Brendan O’Connell e-mail: brendan.oconnell@jcu.edu.au Phone: ++61 7 4781 5081 FAX: ++61 7 4781 4019 1
  2. 2. The Changing Face of the US SEC’s Enforcement Investigations (AAERs) into Financial Statement Fraud in the Post-Enron Environment Abstract This study examines the U.S. SEC’s investigations into financial statement fraud through an analysis of Accounting and Auditing Enforcement Releases (AAERs) from 2002 to 2005. Our study seeks to correct perceived deficiencies (Briloff, 2001; O’Connell, 2001) in the sampling process employed in the COSO Report (1999) which examined AAERs from 1987 to 1997. This paper is also motivated by the need to examine the changing environment, post-Enron, toward regulation of accounting fraud. 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 finds evidence of changes in SEC enforcement activities since the COSO Report (1999). Specifically, we find that enforcement activities have increased substantially post-Enron and the companies subject to AAERs were, on average, much larger, more profitable and the frauds more substantial than those exhibited in the COSO Report (1999). These findings suggest that the SEC has become more aggressive at pursuing larger companies for financial statement fraud in the post-Enron environment. Key words: institutional theory; financial statement fraud; SEC; Accounting and Auditing Enforcement Releases. 2
  3. 3. The Changing Face of the US SEC’s Enforcement Investigations (AAERs) into Financial Statement Fraud in the Post-Enron Environment “In law, what plea so tainted and corrupt, But, being seasoned with a gracious voice, Obscures the show of evil?” William Shakespeare in The Merchant of Venice, act 3, sc. 2, l. 75-7. In Shakespeare’s The Merchant of Venice a major theme is that of deception and disguise. People are deceived by ornament. The outward appearance of people, ideas, laws, and objects can sometimes mask reality (Perell, 2006). The forthcoming analysis of the U.S. 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 financial statement fraud within US companies during the period 2002 to 2005. Employing a cross-case analysis of AAERs, 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 expose the “ornament” that masks the reality of these companies. In addition to our intention to enhance understanding of a sample of US financial statement frauds, the present investigators also seeks to compare our findings with those reported by the Committee of Sponsoring Organizations of the Treadway Commission 1987-1997 (COSO Report, 1999). Specifically, we aim to identify common characteristics of financial statement fraud pre and post issuance of that report and whether the focus of SEC prosecutions has changed over that period. The reason that we 3
  4. 4. have selected this comparison is to study whether “high profile” 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 theoretical basis of our study is drawn from institutional theory. Institutional theory adopts an open system perspective where organizations are strongly influenced by their environments (DiMaggio & Powell 1983; Bealing et al. 1996). We hypothesize that, post-2001, the SEC responded to the voluminous criticism of companies legislation and enforcement emanating from the major accounting scandals by significantly increasing the number and scale of its enforcement activities to ensure maintenance of its societal legitimacy. LITERATURE REVIEW COSO Report (1999) In 1999, the Committee of Sponsoring Organizations of the Treadway Commission (COSO) 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 (see, for example, Wells, 2001; Beasley, Carcello, Hermanson, & Lapides, 2000). The COSO Report (1999) boasted that, “For the first time, we have a clear understanding of the who, why, where and how of financial reporting fraud” (p.1.). These researchers analyzed 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 4
  5. 5. relate to financial statement reporting. A random sample of 220 cases of financial statement fraud were subjected to analysis, however, the researchers found that only in 99 cases were they able to obtain the “last clean financial statements” (p.15). Major findings of the COSO Report were that the companies involved in financial 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 large relative to company size and were not isolated to a single period; and, typical fraud techniques involved overstatement of revenues (COSO Report, 1999: 5-6). Criticisms of AAERS and the COSO Report (1999) There have been several studies utilising AAERs which have alluded to their limitations (see, for example, Feroz et al., 1991; Bonner et al., 1998) and critiques of the COSO Report (1999) itself (see, for example, Briloff, 2001; O’Connell, 2001). In terms of the limitations of AAERs themselves, Feroz et al. (1991) report 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) also emphasized the strong possibility of selection bias emanating from reliance on AAERs. They specified that these enforcement actions might reflect specific SEC agendas prevailing at the time of the sample selection (p. 505). 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 financial statement frauds. 5
  6. 6. The SEC admits that its enforcement program is designed to “concentrate on particular problems areas and to anticipate emerging problems” (SEC, 1989, p. 1). As an example of this SEC agenda bias, Feroz et al. (1991) reported that 70% of all AAERs issued between 1982 and 1989 related to alleged overstatement of accounts receivables and inventories by firms. Furthermore, Feroz et al. (1991, p. 111-2) highlighted that interviews with current and former SEC officials 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 COSO Report (1999) itself, perhaps the most high profile 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 profile cases that, in his view, were “contaminating the accounting and financial reporting environment” (p.126). Briloff was especially critical of the obvious lack of high profile cases in the sample given the small size of companies reflected 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 financial reporting environment.” (p.126). 6
  7. 7. O’Connell (2001) supported Briloff’s claim stating that “researchers who have used AAERs also recognize the limitations of relying on AAERs to evaluate financial 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 financial data on sample firms 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) is that “companies committing financial statement fraud were relatively small” (p 2). He argued that this finding is only valid if one assumes AAERs are truly representative of all financial statement fraud and if one assumes that the omitted firms are similar in character to those 99 firms 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 firms. Moreover, when a population is skewed one way and a random sample is taken from that population, then the resultant sample is likely to reflect that particular distribution shape (in this case, a plethora of small firms 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 profile cases of financial 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 7
  8. 8. drives these high profile cases. To enhance the usefulness of the COSO study, he advocated a sampling approach that includes large, high-profile cases. The SEC and Institutional Theory Any study that utilizes AAERs as a primary data source cannot draw conclusions from them without first 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), proposes that many aspects of formal organizational structures, policies and procedures result from prevailing societal attitudes and the views of important constituents (p.53.). Organisations obey these rules and requirements, not just on efficiency grounds, but also to enhance their legitimacy, resources, and survival capacities (Kondra & Hinings 1998). Institutional pressures operate in conjunction with other forces such as competition to effect ecological dynamics. Organisational behaviour is inextricably ingrained in a vibrant system of interrelated economic, institutional, and ecological influences (DiMaggio & Powell 1983). Of relevance to the present study, Bealing et al. (1996) utilized 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 organisation attempting to justify its existence and role in the financial markets. They found “that in order for the SEC as an organization to become legitimated…as part of the regulatory arena, it had to 8
  9. 9. 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 financial statement and accounting fraud. Certainly the pronouncements of politicians (see, for example, Bush, 2002a;b;c) and the passage of the Sarbanes-Oxley Act of 2002 reflect 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. Research Hypotheses 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 hypothesize that the changed institutional environment following the accounting scandals may have impacted on the level of AAERs issuance, the size of 9
  10. 10. companies subject to AAERS and the nature of the allegations. Specifically, we test the following six hypotheses: 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 first hypothesis is based on the hostile environment faced by the SEC and other regulators in the wake of Enron, WorldCom and other accounting scandals (see, for example, Rockness & 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 & 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 been an increase in the size of companies subject to issuance of AAERs by the SEC in the period after 2001, that is, post the US accounting scandals. This second hypothesis reflects the “high profile” 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 SEC would aggressively pursue “high profile” cases and trumpet any prosecutions as vindication of its pivotal role in ensuring reliable financial disclosures to investors. As noted by De Fond and Smith (1992) “the SEC Enforcement Division chooses cases that enhance its stature as an effective law enforcement agency” (p.144). It follows that larger companies are likely to have been subject to AAERS since 2001. It may also be plausible that the Enron fallout 10
  11. 11. 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 profile” 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), 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). 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 hypotheses are directly derived from the findings of the COSO Report (1999). Specifically, 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 fiscal 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 (p.5-6). 11
  12. 12. H3: Companies subject to issuance of AAERs by the SEC are likely to exhibit poor financial condition in the period leading up to the period of alleged accounting fraud. H4: 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. H5: 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. H6: 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 CFO. RESEARCH METHODOLOGY The present investigators commenced the study by identifying those AAERs that involved an alleged breach of Rule 10(b) – 5 of the Securities Exchange Act 1934 or Section 17(a) of the Securities Act of 1933 or other Federal anti-fraud statutes. These are the sections that represent the primary antifraud provisions relating to financial reporting. Excluded from the analysis were restatements of financial reports due to errors or any activities that did not result in a violation of federal antifraud 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 identified 350 AAERs that related to fraudulent financial reporting between 2002 and 2005 (a period deliberately chosen to reflect the post-Enron fallout). However, there were multiple AAERs for some cases amongst the 350 identified. Where there were multiple AAERs relating to one company, these were counted as one1. This reduced the number of companies to 330. A random 1 In some cases a separate AAER was issued for the company and for each individual executive involved in the accounting fraud. 12
  13. 13. sample of 55 was taken from this group of companies which compares to a final sample of 99 cases for the COSO Report. Appendix One lists each of the 55 cases used in our sample together with key characteristics of each case2. Table 1 below shows a comparison of the sampling approach used in the present study to that of the COSO Report (1999). INSERT TABLE 1 ABOUT HERE 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 five large “high profile” cases of financial statement fraud. The five cases examined are Waste Management, Qwest Communication, Tyco International, HealthSouth Corporation and Adelphia Communications. This approach avoids the sampling problem of the COSO Report (1999) which led Briloff (2001) to conclude that it was not representative of the “really stinking stuff which is contaminating the accounting and financial reporting environment” (p.126). As a consequence of this sampling approach, high profile companies make up 8.3% of the total sample. None of these cases were duplicated in the random sample. A detailed analysis of the “high profile 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 (see, for example, Benston & Hartgraves, 2002; 2 Briloff (2001) was also critical of the absence from the COSO Report (1999) of such a list. 13
  14. 14. 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 specifically examined in this study. All of these six were also studied in the COSO Report (1999): the size of the company committing the alleged financial statement fraud; the financial condition of 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 fiscal period; and, the typical financial 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 financial 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 COSO Report (1999). RESULTS AND DISCUSSION SEC Issuance of AAERS Our findings support hypothesis one 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#123 and ending with AAER#1004. From this process, we identified nearly 300 companies involved in alleged instances of fraudulent financial reporting (p.12). 14
  15. 15. The final sample of the COSO Report was then randomly selected from that group of 300. If we compare these figures to those of the present investigation, there has been a marked increase in issuance of AAERs in recent 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 identified 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 20053. It follows that the SEC issued AAERs at a far higher rate in the period 2002 to 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 specifically related to financial 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 findings could be explained by two possibilities. First, the SEC seeking to legitimize itself to stakeholders through a greater focus on possible fraudulent financial reporting. While the SEC did receive an injection of funding from 2002 onwards to combat corporate fraud (see, 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. Second, the SEC stepped up its enforcement activities post-Enron following a realization that financial statement fraud was more prevalent than previously envisaged. 3 It should be noted that the COSO Report (1999) did not report a year-by-year dissection of AAERs. 15
  16. 16. Size of Companies Committing Financial Fraud The COSO Report (1999) stated that the sample companies are relatively small in size. The company size (total assets and revenue) comparisons between the COSO Report (1999) and the present study are shown in Table 2. INSERT TABLE 2 ABOUT HERE The COSO Report (1999) stated that the “companies committing financial statement fraud were relatively small” and that “most of the sample companies ranged well below $100 million in total assets” (p.5). As depicted in Table 2, the COSO Report (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). These figures represent a 522% increase in the mean total assets and a 1,092% rise in the median. Turning to total revenues, the COSO Report (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 figures depict a 1,232% increase in the mean total revenue and a 380% rise in the median. It should be noted that we did not conduct statistical comparisons of the two groups (present study sample versus COSO Report sample) relating to company size because the authors of the COSO Report (1999) did not identify which specific AAERs were included in their analysis. Their report provided only aggregated findings and hence a valid statistical comparison such as a chi-square test is impossible4. Standard deviations are also not reported because our sample (together with that of the COSO Report, 1999) 4 It should be noted that both Briloff and O’Connell personally contacted the authors of the COSO Report (1999) in 2001 in an effort to obtain details of the AAERs included in their sample but were informed that due to confidentiality issues with regard to the Treadway Commission they were not prepared to release this information to us. 16
  17. 17. is heavily positively skewed. Reliance on a standard deviation would be misleading in such a skewed distribution and consequently, median and quartile results are provided instead to provide a more meaningful picture of the empirical data (Tabachnick & 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, hypothesis two 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 findings. 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 profile” companies post-2001 for prosecution consistent with an institutional theory argument or because they came to the realization that financial 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. 17
  18. 18. Profitability of Companies Committing Financial Fraud Consistent with the COSO Report (1999), we examined the net income for the year prior to commencement of the fraud. Our findings are displayed in Table 3 and show a far higher net income figure for our sample (mean of $48.3 million, median of $1.8 million) when compared to the COSO Report (mean of $8.6 million, median of $175,000). This represents a 463% increase in the mean and a 929% increase in the median. INSERT TABLE 3 ABOUT HERE These findings contrast somewhat with the COSO Report (1999) which concluded that “pressures of financial strain or distress may have provided incentives for fraudulent activities for some fraud companies” (p.5). Companies in the present investigation were generally profitable 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%) reported a loss in the period immediately prior to the alleged fraud. These findings do not support hypothesis three which stated that companies subject to issuance of AAERs by the SEC are likely to exhibit poor financial 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 financial statement fraud despite many of the sample being quite profitable entities. It is apparent that pressure to achieve Wall Street analysts’ profit 18
  19. 19. 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 first 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, July 23, 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 reclassified rent and salary expenses that Master Graphics had already paid to its division presidents in the first quarter to assets on the company’s balance sheet thus reducing expenses and increasing income (AAER No. 2035, Master Graphics, June 14, 2004). Stockholders’ Equity (Deficit) of Companies Committing Financial Fraud Our analysis of stockholders’ equity in the period preceding the financial fraud reveals a similar picture to that of the profitability analysis. As shown in Table 4, the COSO Report (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 findings reflect a 753% higher mean and a 1,062% larger median for the sample in the present study. Again, hypothesis three is not supported by these findings. INSERT TABLE 4 ABOUT HERE 19
  20. 20. Executives Named in the AAERs Table 5 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 Chief Executive Officer (141 companies or 72% of the sample) was the highest ranking executive involved in most fraud cases5. In the present investigation, the senior executive most frequently named was the Chief Financial Officer (33 companies representing 60% of the sample). There also seems to be a greater spread of individuals cited in this study. The Controller (13% of sample), Chief Operating Officer (16%) and other Vice President Positions (20%) 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 reflect the greater size and complexity of the companies in our study. Our findings generally support hypothesis six 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 5 shows this is clearly the situation in most cases. INSERT TABLE 5 ABOUT HERE Our qualitative analysis of AAERs offers important insights into the direct involvement of unscrupulous senior executives in many of the frauds: 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 officers expressed scorn for accounting principles. … As a 5 It should be noted that in determining Table 5, the highest managerial title for an individual was used. 20
  21. 21. result of the pressure for profits at all costs and disdain for accounting principles by former senior officers … Keltec’s controller knowingly allowed improper accounting practices … Moreover, Signal Tech’s senior officers personally directed specific 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, March 27, 2002). During the first 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, December 16, 2002). Cumulative Dollar Amount of Fraud for a Company As shown in the Table 6 the average fraud amount in our sample involved $137 million of cumulative misstatement or misappropriation (median of $10.8 million)6. This is much higher than those found in the COSO Report (1999) where a mean and median of $25 million and $4.1 million respectively were reported. This comparison indicates a 448% increase in the mean size of the fraud and a 163% 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% of median total assets ($15.7 million). In our sample, the median fraud of $10.8 million represented 6% of median total assets ($186.9 million). In both samples, the median fraud amount considerably exceeded the median net income. It follows that hypothesis four is supported as the frauds do, on average, involve large amounts relative to company size. 6 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, [found at http://www.sec.gov/litigation/litreleases.shtml] to ascertain the precise fraud amount. 21
  22. 22. INSERT TABLE 6 ABOUT HERE Qualitative analysis of the AAERs shows a recurring theme that executives perceived that their manipulations of reported earnings would have a significant impact on the share price and their associated bonuses: The compliant alleges that Gless [former CFO] and other Peregrine senior officers engaged in deceptive practices to artificially inflate Peregrine’s revenue and stock price, and that Gless then took fraudulent action to conceal the scheme (AAER No. 1759, Peregrine Systems, April 16, 2003). In 2001 and 2002 Huntington reported inflated earnings in its financial 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, June 2, 2005). Length of Fraud Period The COSO Report (1999) found that the average fraud was for two years with a median of 21 months (p.30). Table 7 indicates that 36% of frauds in the current study related to one year or less with 36% between one and two years, and 18% lasting for three years. In all, 64% of all frauds in our sample were for greater than one year. These results are consistent with hypothesis four in indicating that many frauds occur across multiple periods. INSERT TABLE 7 ABOUT HERE Common Financial Fraud Techniques As can be seen in Table 8, by far the most common technique used to fraudulently misstate financial statement information in our sample involved deliberate overstatement 22
  23. 23. of revenue. In fact, 96% of alleged fraud involved this method. In the COSO Report (1999), 50% 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 financial statement information was the overstatement of assets (53%). 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% in the COSO Report to 11% in the present study). The above findings support hypothesis five in that the sample frauds commonly involved improper revenue recognition or overstatement of assets. INSERT TABLE 8 ABOUT HERE Our qualitative analysis of AAERs provided detailed descriptions of the types of techniques employed by executives to misrepresent the company’s financial 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 fictitious customer, and used other fraudulent techniques to inflate Anicom’s revenues” (AAER No. 1554, Anicom, May 6, 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 excess inventory. Signal Tech’s former Chairman and CEO, former CFO, and other former senior corporate officers, knew of and in multiple instances personally directed improper 23
  24. 24. accounting practices. On several occasions the former chairman and other senior officers even dictated specific misleading entries to be made on Keltec’s books (AAER No. 1534, Signal Technology, December 16, 2002). ANALYSIS OF FIVE HIGH PROFILE COMPANIES Two of the main criticisms of the COSO Report (1999) by Briloff (2001) and O’Connell (2001) are a paucity of “high profile” cases in that sample and the lack of disclosure of the specific AAERs scrutinized by those investigators. In contrast, the present study provides details of all AAERs examined (see Appendix One) and uses a sampling approach that specifically includes an analysis of five high profile cases during the study period. The five frauds examined are Waste Management, Qwest Communication, Tyco International, HealthSouth Corporation and Adelphia Communications. Table 9 displays a summary of the key characteristics of the five major frauds. Appendix Two provides an overview of each of these five frauds. INSERT TABLE 9 ABOUT HERE Table 9 shows that these five 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 maximum of $3.5 billion (mean of $1.9 billion). It should also be noted that these fraud amounts were significant when compared to each company’s revenue or profit situation. For example, in 60% of the cases the accumulated fraud amount exceeded the company’s total revenue from the previous year’s financial result. In all cases the frauds covered several reporting periods with a minimum of 4 years and a 24
  25. 25. maximum of 7.5 years (mean of 5.5 years). The CEO was implicated in the fraud in all cases with the CFO prosecuted in 80% of them. In 40% of the cases, the company was quite profitable in the year preceding the fraud (as measured by net income). In another 40%, the company reported a large loss the previous year and in the remaining case the company reported a small loss. Artificial inflation 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 March 15, 2005). This is a looting case …it involves egregious, self-serving and clandestine misconduct by the three most senior executives at Tyco (AAER No 1839, Tyco International, issued August 13, 2003). The ubiquitous issue of pressure to appease analysts’ forecasts also was a common theme: The complaint was that these eight officers artificially 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 financial management indicated the company would miss its quarterly targets, the Global Business Markets officers would bridge the gap by fraudulently mischaracterizing these transactions (AAER No 1726, Qwest Communications, issued February 25, 2003). In summary, the findings from these five high-profile cases largely support those of the 55 randomly selected cases. The extent and nature of the frauds was significant and the companies involved were substantial in size. CONCLUSION 25
  26. 26. This study set out to examine the U.S. SEC’s investigations into financial 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 find evidence of changes when compared to the COSO Report (1999). Specifically, we found that there far more AAERs issued post-Enron and the companies involved were, on average, much larger, more profitable and the frauds more substantial than those exhibited in the COSO Report (1999). These findings hold even before considering the additional five high profile 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 financial 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 insufficient number of “high profile” companies included in the sample of the COSO Report (1999) . We believe that the addition of case studies on five 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: 5) concluded companies committing financial 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 26
  27. 27. 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 fictitious 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. 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 financial statement fraud. This is because AAERs may reflect the prevailing agenda of the SEC (Bonner et al., 1998) or differ in their 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 (see, for example, De Fond & Smith, 1991; Bonner, Palmrose, & Young, 1998). Third, the observed rise in enforcement actions and the size of firms prosecuted may be explained by a variety of factors other than legitimization such as a greater awareness of the 27
  28. 28. possibility of fraud post-Enron. Fourth, if one accepts that the COSO Report (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. Avenues for future research include more case-based research into financial 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 SEC to ascertain information about prevailing SEC agendas and processes and their specific impact on AAERs. 28
  29. 29. APPENDIX ONE SUMMARY OF THE ACCOUNTING AND AUDITING ENFORCEMENT RELEASES (AAERs) n=55 INCLUDED IN THE SAMPLE AAER Date Company name Fraud Technique Fraud Fraud Executives Involved No. Issued Amount Period 1489 02.01.0 InaCom Corp Inflating income $30.9m 1999 CFO, Asst Controller 2 by various methods 1503 05.02.0 Critical Path Inc Backdating sales $21.7m 2000 President & Vice 2 transactions President 1509 01.03.0 Eagle Building False sales figures $10.6m 2001 CEO 2 Techniques Inc 1514 06.03.0 Freedom Surf Inc Fraudulently $5.1m 2000 President, Vice- 2 valuing assets President 1517 12.03.0 Gunther Overstatment of $2.16m 1997-19 CFO 2 International Ltd assets & 98 Revenues, understatement of Expenses 1534 27.03.0 Signal Technology Understatement of $2m 1997-19 CEO, CFO, CTO 2 Corp losses approx 98 1543 22.04.0 Teltran Intn’l Group Overstatement $1.4m 1999 CEO 2 revenues & approx earnings 1596 05.06.0 Physician Computer Understating exp, $57.3m 1996-19 COO, CFO, Dir of 2 Network Inc inflating revenues 97 Acctg 1577 14.06.0 Cylink Corporation Improperly $10.8m 1997-19 CFO 2 recognizing 98 revenue 1520 20.08.0 Centennial Overstatement of $40m 1994-19 CEO, CFO 2 Technologies Inc fixed assets, 95 revenues, inventory 1623 04.09.0 Sunbeam Channel Stuffing $93m 1996-19 CEO, CFO 2 Corporation et al 98 1628 18.09.0 Sabratek Corp Overstatement of $18.3m 1998-19 CEO,CFO,CAO 2 sales 99 1632 25.09.0 Dynegy Overstating net $474m 2001-20 CFO 2 income 02 1638 01.10.0 Interspeed Inc Fraudulent $9m 2000 CFO, V-President 2 Revenue Recognition 1637A 25.11.0 Peregrine Systems Inflating income $259m 1999-20 CEO,CFO, et al 2 Inc by various 03 methods 1691 16.12.0 Mercator Software Understatement of $2.4m 2000 CFO, Controller 2 Inc expenses 1734 07.03.0 Hexagon Fraudulent $368.6m 1996 CFO 3 Consolidated recognition of (HCCA) assets 1741 17.03.0 Anicom Inc Fictitious Sales $80m 1998-20 CEO,CFO,COO 6 00 1735 10.03.0 American Tissue Inc Inflate revenues $49.9m 2000-20 CEO,V-P Finance 3 assets & profits 01 29
  30. 30. AAER Date Company name Fraud Technique Fraud Fraud Executives Involved No. Issued Amount Period 1763 24.04.0 Chancellor Inflate revenues $3.3m 1998 CEO,CFO,COO,CAO 3 Corporation assets & profits 1767 30.04.0 Candie’s Inc Record revenue $4.4m 1997-19 CEO,COO,CFO 3 prematurely 99 1783 15.05.0 Just for Feet Inc Overstating $8.3m 1997-19 VP 3 existing assets. 99 Overstating revenue 1793 04.06.0 Madera Inflated asset $0.68m 1999 CEO 3 International Inc values 1796 05.06.0 Xerox Corporation Record revenue $3billion 1997-20 CEO,CFO,COO, 3 prematurely 00 Controller 1813 14.07.0 Carnegie Intnl Corp Fraud. Reporting $8.64m 1998-20 CEO,CFO,Sec, 3 revenue & income 00 Director 1849 25.08.0 Solucorp Industries Recorded fictitious $354m 1997 CFO, VPs 3 Lts revenue 1854 11.09.0 Brightpoint Inc Overstating $15m 1998-20 CFO, Director 3 income 00 1862 11.09.0 Cais Internet Inc Record revenues $1m 2000 VP Business Dev 3 prematurely 1864 18.09.0 Homestore Inc Recog. Own cash $119m 2000-20 CEO,CFO, Various 3 as revenue 02 1886 02.10.0 Analytical Surveys Inflated revenue $6.5m 1999 CEO,COO,Controller 3 inc earnings 1912 14.11.0 Gateway Inc Record revenue $154m 2000 CEO,CFO,Controller 3 prematurely 1915 17.11.0 Schick Technologies Record revenue $9.01m 1998-19 CEO, VP Sales 3 Inc prematurely 99 marketing 1928 18.12.0 Hanover Record fictitious $17.5m 2000-20 CEO,COO,CFO 3 Compressor revenue 01 Company 1958 17.02.0 Performance Food Overstate income $3.8m 2000-20 Manager of 4 Group Company fraudulently 01 Subsidiary 1963 25.02.0 ClearOne Inflating revenues $21.2m 2001-20 CEO,CFO 4 Communications Inc 02 1975 11.03.0 Conseco Finance Overstating $929.6m 1999-20 CFO, CAO 4 Corp existing assets 00 1981 31.03.0 McKesson HBOC Premature Recog $20m 1999 CFO 4 income 1985 01.04.0 Powerball Altered bank $0.05m 2002-20 Pres-Director 4 International Inc statements 03 1993 27.04.0 Professional Inflate income $3.1m 2000 Controller 4 Transportation recording another Group entities sales 1998 30.04.0 Quadramed Record fictitious $5m 1998-19 CFO 4 Corporation revenue 99 2035 14.06.0 Master Graphics Inc Fraud overstating $0.63m 1999 CEO,CFO 4 net income 2050 08.07.0 Measurement Capitalising $7.76m 2000-20 CFO 4 Specialities Inc Expenses 01 (inventory) 2053 09.07.0 Sport-Haley Inc Overstated WIP $1.2m 1999 External Auditors 30
  31. 31. 4 inventory AAER Date Company name Fraud Technique Fraud Fraud Executives Involved No. Issued Amount Period 2109 24.09.0 Electro Scientific Overstated $6.9m 2002 CEO,CFO,Controller, 4 Industries income, Gen Counsel understated expenses 2133 10.11.0 Computer Back-dating $400m 2001-20 General Counsel 4 Associates Int contracts to inflate 05 revenues 2167 13.01.0 Royal Ahold/US Inflating income $700m 2001-20 Various 5 Foodservice letters to auditors 02 2194 02.03.0 Advanced Overstate pre-tax $9.2m 2001-20 A-P Advertising, Dir 5 Marketing Service earnings 03 Adv. 2199 04.03.0 TALX Corporation Capitalizing $4.1m 2001 CEO,CFO 5 Expenses 2218 24.03.0 IGO Corporation Improperly $2.9m 1999-20 CEO,CFO,COO 5 recording revenue 00 2222 04.04.0 Aurora Foods Under reported $43m 1998-19 CEO,CFO,COO, 5 trading expenses 99 Exec V-P 2223 06.04.0 Team Fraudulent circular $21.9m 1999-20 CEO 5 Communication sales contracts 01 Group 2251 02.06.0 Huntington Fraudulent $25.6m 2001-20 CEO,CFO, 5 Bancshares inc misstatements inc 02 Controller & Exp 2321 29.09.0 The Penn Traffic Overstatement of $11m 1999-20 Director of Subsidiary 5 Company income 02 2345 16.11.0 Patterson-UTI Embezzlement by $77.5m 2001-20 CFO 5 Energy CFO 05 2351 30.11.0 Friedman’s Inc Premature recog $3m 2001-20 Senior Executives 5 expense discounts 03 31
  32. 32. Appendix Two Summary of the Facts Alleged in AAERS of Five Major Financial Statement Frauds during the Study Period 1. Waste Management Inc. Sources: AAER Numbers 1405 to 1410 (all issued June 19, 2001); AAER No 2116 issued September 30, 2004. Waste Management Inc provided comprehensive solid and hazardous waste services, energy recovery services, and environmental technologies, engineering and consulting services. The SEC found that the company’s financial statements were not presented fairly, in all material respects, in conformity with GAAP for 1993 through 1996 and that the company’s auditors, Arthur Andersen, issued materially false and misleading audit reports (AAER 1405). The audit firm was “censured”. The four Andersen partners were banned from practice for a number of years and all but one subjected to a monetary penalty (AAER No. 1410). In addition, the SEC charged the founder and five other senior executives of Waste Management with perpetrating a massive financial fraud lasting more than five years. The Commission alleged that, beginning in 1992 and continuing into 1997, defendants engaged in a systematic scheme to falsify and misrepresent the Company’s financial results. The officers involved included the CEO, COO, CFO, CAO, the General Counsel and Vice President of Finance (AAER No 2116). 32
  33. 33. Appendix Two (cont.) To summarize the charges of improper accounting practices, the defendants “resorted to improperly eliminating and deferring current period expenses to inflate 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 landfills as they were filled with waste; refusing to record expenses necessary to write off the costs of unsuccessful and abandoned landfill development projects; establishing inflated 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 sufficient reserves (liabilities) to pay for income taxes and other expenses (AAER No 2116) . 33
  34. 34. Appendix Two (cont.) 2. Qwest Communications International Inc (Qwest) Source: AAER No 1726 issued February 25, 2003; AAER No 2209 issued on March 15, 2005. Qwest is a telecommunications and internet services company with corporate headquarters in Denver, Colorado. Qwest was promoted to investors and market analysts as a modern, progressive, new age technology company. Senior executives of the Company, including the CEO, CFO and COO, promoted its EBITDA (Earnings Before Interest, Taxation, Depreciation and Amortization) figures and set aggressive earnings and growth targets. The SEC Complaint (AAER No 2209) states that “the business unit executives made it clear that subordinates had to meet or exceed these aggressive earnings targets at all costs” (p.17). The AAER also alleges that it was made clear to all employees that falling short of the revenue projections was totally unacceptable and could lead to dismissal. Over the next three years there were serious violations of Generally Accepted Accounting Principles (GAAP) created to assist meeting analysts expectations. The SEC’s complaint was that the CEO, CFO, COO and many other senior executives, committed fraud and other violations of the federal security laws. The Commission alleged that the defendants engaged in a multi-faceted fraudulent scheme designed to mislead the investing public about the Company’s revenue and growth. The main charges claimed that the Company fraudulently recognized revenue from non- recurring revenue sources over a period of three years from 1999 to 2002. 34
  35. 35. Appendix Two (cont.) In 2003, the SEC filed civil fraud charges against eight officers and former officers of Qwest associate Company global business and its markets. The complaint was that these eight officers artificially accelerated Qwest’s recognition of revenue in two equipment sale transactions for its Global Business Markets Unit (AAER No 1726). It is alleged that that when the Qwest financial management indicated the company would miss its quarterly targets, the Global Business Markets officers would bridge the gap by fraudulently mischaracterizing these transactions. The cumulative amount of fraud for the three years from 1999 to 2002 was $3.5 billion. 35
  36. 36. Appendix Two (cont.) 3. Tyco International Ltd (Tyco) Source: AAER No 1839 issued on August 13, 2003. Tyco is a diversified manufacturing and service company that has business segments in fire and security services, electronics, healthcare and specialty products and undersea telecommunications networks. It operates in 100 countries. The AAER stated that “this is a looting case” and “it involves egregious, self-serving and clandestine misconduct by the three most senior executives at Tyco.” The misconduct and violations covered from at least 1996 until June 2002. It is suspected that investors were misled by a pattern of improper and illegal activity by former management that included unauthorized payments to dozens of Tyco employees at various levels. In short, the CEO and CFO accepted hundreds of millions of dollars in secret, unauthorized and improper low interest or interest-free loans and compensation from Tyco. Moreover, these payments were concealed from shareholders. The federal security laws required disclosure of executive loans, compensation and related party transactions. By failing to disclose these matters, it is claimed that the CEO and CFO violated the antifraud provisions of the federal security laws. The engagement audit partner from Price Waterhouse Coopers for Tyco was banned from practicing as an accountant. The CEO and CFO of Tyco were found guilty of stealing $567 million from the company and both received jail terms of 25 years. 36
  37. 37. Appendix Two (cont.) 4. HealthSouth Corporation Source: AAER no 1744 issued on March 20, 2003. HealthSouth Corporation is America’s largest provider of outpatient surgery, diagnostic and rehabilitative healthcare services. It owns or operates over 1800 different facilities throughout the USA and abroad (SEC Complaint, 2003). The CEO of HealthSouth orchestrated a scheme to artificially inflate reported earnings to match stock analysts’ expectations so as to maintain the stock price. Between 1999 and the second quarter of 2002, HRC intentionally overstated its earnings by at least $1.4 billion. The following table shows the approximate amounts of overstated “Income Before Income Taxes and Minority Interests since 1999” (AAER No. 1744). The total misstated amount in the table is $1.4 billion. Income (Loss) 1999 2000 2001 6 mths ended in $millions Form 10-K Form 10-K Form 10-K June 30, 2002 Actual $(191) $194 $9 $157 Reported 230 559 434 340 Misstated Amount 421 365 425 183 Misstated Percentage 220% 188% 4.722% 119% The AAER states that the senior officers 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 financial results of HealthSouth fell short of analyst expectations, the CEO would tell his executives to “fix it” by recording false earnings on HRC’s accounting records to make up the shortfall. The AAER states that senior accounting personnel would then convene a meeting to remedy the earnings shortfall. 37
  38. 38. Appendix Two (cont.) 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). The CEO, Richard Scrushy, was indicted on 85 charges but, in 2005, was acquitted on all counts of conspiracy and fraud. He has been further indicted of bribery and fraud and found guilty in 2006. 5. Adelphia Communications Corporation Source: AAER No 1599 issued on July 24, 2002. Adelphia is the sixth largest cable television provider in the United States. The Adelphia fraud is a case where a group of insiders (in this case, the Rigas family) defrauded their company by exploiting a lack of internal controls. It was alleged that the Rigas family manipulated financial records at Adelphia and, to hide the mounting debts of the company, engaged in the creation of sham transactions and spurious companies. The SEC charged that Adelphia, at the direction of the individual defendants: (1) fraudulently excluded billions of dollars in liabilities from its consolidated financial statements by hiding them in off-balance sheet affiliates; (2) falsified operations statistics and inflated Adelphia’s earnings to meet Wall Street’s expectations; and (3) 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). In subsequent litigation, John and Timothy Rigas (father and son) were found guilty of conspiracy, bank fraud and securities fraud and sentenced to 15 years in prison. 38
  39. 39. Table 1: AAER Sample Selection Process for Present Investigation Versus COSO Report (1999) COSO Report (1999) Present Study (as cited in O’Connell, 2001: 170) Approximately 800 Approximately 870 AAERs issued in AAERs issued in periods 1987-97 period 2002-2005 300 firms involved in “Financial Statement Approx 330 firms Fraud” involved in “Financial Statement” Fraud 220 Cases “randomly selected” from 300 55 Cases firms randomly selected” from 330 items and used in the study 204 cases remain after 16 more cases are removed “due to data limitations” 5 “High Profile” cases selected and added to 99 cases only where study researchers were able to obtain “last clean financial statement” Total cases in study 60 39
  40. 40. Table 2: Total Assets and Revenue for Sample Firms in the COSO Report (1999) and the Present Study Total Assets % Total Revenue % (in $ 000’s) Change (in $ 000’s) Change COSO This Study COSO This Study Report Report (1999) (1999) n=99 n=55 n=99 n=55 Mean $532,766 $3,314,857 522.2 $232,727 $3,098,824 1,231.5 Median $15,681 $186,951 1,092.2 $13,043 $62,580 379.8 Min. 0* $588 0* 0* Value 1st $2,598 $22,849 779.5 $1,567 $14,841 847.1 Quartile 3rd $73,879 $567,925 668.7 $54,442 $822,439 1,410.7 Quartile Max. $17,880,000 $43,599,900 $11,090,000 $48,557,718 Value Note: Figures were taken from the last financial statement prior to fraud. *Minimum values of zero reflect companies that were in development phases and hence had no revenue or assets in the period prior to the fraud. Table 3: Net Income for Sample Firms in the COSO Report (1999) and the Present Study Net Income / Loss (in $ 000’s) % Change COSO Report This Study (1999) n=99 n=55 Mean $8,573 $48,274 463.1 Median $175 $1,802 929.7 Minimum ($37,286) ($879,555) Value 1st Quartile ($448) ($1,678) 274.6 3rd Quartile $2,164 $45,678 2,010.1 Maximum $329,000 $1,206,000 Value Note: Figures were taken from the last financial statement prior to fraud. 40
  41. 41. Table 4: Stockholders’ Equity (Deficit) for Sample Firms in the COSO Report (1999) and the Present Study Stockholders’ Equity (Deficit) % (in $ 000’s) Change COSO Report This Study (1999) n=99 n=55 Mean $86,107 $735,084 753.7 Median $5,012 $58,237 1,062.0 Minimum ($4,516) ($467,706) Value 1st Quartile $1,236 $7,838 534.1 3rd Quartile $17,037 $230,030 1,250.2 Maximum $2,772,000 $12,785,239 Value Note: Figures were taken from the last financial statement prior to fraud. Table 5: Types and Frequencies of Individual Executive Positions Named in AAERs for Sample Firms in the COSO Report (1999) and the Present Study Types and Frequencies of Individuals Named COSO Report (1999) This Study # of % of Fraud # of % of Companies Cases Companies Fraud Cases Chief Executive Officer 141 72% 26 47% (CEO) Chief Financial Officer 84 43% 33 60% (CFO) Controller 41 21% 7 13% Chief Operating Officer 13 7% 9 16% (COO) Chief Accounting Officer 0 0% 3 5% (CAO) Other Vice President 35 18% 11 20% Positions Board of Directors 21 11% 6 11% Lower Level Personnel 19 10% 1 2% Outsiders (eg Auditors, 74 38% 1 2% Customers) No Title Given 30 15% 1 2% Other Titles 24 12% 6 11% 41
  42. 42. Table 6: Cumulative Fraud Amount for Sample Firms in the COSO Report (1999) and the Present Study Cumulative Fraud Amount % (in $ 000’s) Change COSO Report This Study (1999) n=99 n=55 Mean $25.0 $137.0 448.0 Median $4.1 $10.8 163.4 st 1 Quartile $1.6 million $3.95 million 146.9 rd 3 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 7: Number of Financial Periods (Years) Covered by Fraud for Sample Firms in the Present Study Financial Periods (Years) Covered by Fraud Number of % of Total Sample Sample One Year 20 36 Two Years 20 36 Three Years 10 18 Four Years 2 4 Five Years 3 6 Note: Figures were taken from AAERs. n=55 companies. The COSO Report (1999) did not provide data on this variable broken down as above. However, The COSO Report (1999) reported that 14% of the frauds were for one year or less with an average period of approximately two years (p.30). 42
  43. 43. Table 8: Common Financial Statement Fraud Techniques used by Sample Firms in the COSO Report (1999) and the Present Study COSO Report (1999) Present Study Methods Used to Misstate Percentage of Sample Percentage of Sample Financial Statements Using Fraud Method Using Fraud Method Sub- Overall Sub- Overall Category category Category category Improper Revenue Recognition 50% 96% - Recording Fictitious Revenues 26% 36% - Recording Revenues 24% 36% Prematurely - No description/overstated 16% 23% Overstatement of Assets 50% 53% (excluding accounts receivable overstatements due to revenue fraud) - Overstating Existing Assets 37% 35% - Recording fictitious Assets or 12% 7% Assets not owned - Capitalizing items that should 6% 11% be expenses Understatement of 18% 24% Expenses/Liabilities Misappropriation of Assets and 40% 11% Other Miscellaneous Techniques Note: Figures were taken from AAERs. COSO Report (1999) n =204; Present Study n = 55. Subcategories such as “Recording Fictitious 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 fictitiously and recorded prematurely. 43
  44. 44. Table 9: Summary of Key Characteristics of Five Major Frauds during the Study Period Company Size Profitability S/holders Executives Acc. Length Fraud Technique Equity Implicated Amount of Fraud Used of Fraud Total Total Net Income/ Assets Revenue Loss $’million $’million $’million $’million $’million Waste 769.09 270.03 (2.26) 239.4 CEO, CFO, 1,700 5 years Inflating earnings by Management COO, CAO deferring and General capitalizing expenses. Counsel VP – Finance Qwest 8,060 2,242 (849.8) 4,238 CEO, CFO, 3,500 4 years Accelerated Management COO recognition of revenue. Tyco 5,900 6,597 687.9 3,050 CFO, CEO 567 7 years Concealing from International plus shareholders that unauthorized loans were made to CEO and CFO. Theft from company. HealthSouth 6,770 4,000 46.5 3,420 CEO 1,400 7.5 years Overstating earnings Corp. plus by boosting revenue/ reducing expenses. Adelphia 1,640 472.7 (119.2) (1,250) CEO, CFO, 2,300 4 years Hiding of liabilities Communication VP-Finance, off-balance sheet, s Directors inflating earnings. theft of company funds. 44
  45. 45. REFERENCES & BIBLIOGRAPHY Bailey,J. 2000. “Waste Management Settles SEC Charges That It Misled Investors in Spring of ’99,” Wall Street Journal. (Eastern Edition) New York, N.Y., June 22, pg.B.20, Retrieved on 21 June, 2006 from http://proquest.uni.com/pqdweb? index=105&sid=1&srchmode=1&vinst=PROD&fm Bealing, W.E. JR, Dirsmith, M.W and Fogarty, J., 1996. “Early Regulatory Actions by the SEC: Institutional Theory Perspective On The Dramaturgy of Political Exchanges,” Accounting Organizations and Society, Vol 21, No 4, pp 317-338. Beasley, M.S., Carcello, J.V., Hermanson, D.R., Lapides, P.D. 2000. “Fraudulent financial reporting: Consideration of industry traits and corporate governance mechanisms”, Accounting Horizons, December,Vol.14, Iss. 4: 441-55. Benston, G. J. and Hartgraves, A. L. 2002. “Enron: what happened and what we can learn from it”, Journal of Accounting and Public Policy, Vol. 21, Iss. 2, Summer: 105-127. Berman, D.K. and Solomon, D., 2003. “Qwest May Settle SEC Swaps Case – Potential Charges of Fraud Relate to Fiber-Optic Deals With Other Telecom Firms” Wall Street Journal (Eastern edition) New York, N.Y., May 9, pg.A.3. Retrieved on 21 June, 2006 from: http://proquest,uni.com.elibrary.jcu.edu.au/pqdweb? index=1&sid=4&srchmode=1&v Bonner,S.E., Palmrose,Z.V.& Young,S.M., 1998. “Fraud Type and Auditor Litigation: An Analysis of SEC Accounting and Auditing Enforcement Releases,” The Accounting Review, Vol 73, No.4, October: pp 503-532. Briloff, A.J., 2001. “Garbage In/Garbage Out: A Critique of Fraudulent Financial Reporting: 1987-1997 (The COSO Report, 1999) The SEC Accounting Regulatory Process (AAERs) Critical Perspectives on Accounting, pp 125-148. Bush, G.W. 2002a. “President Outlines Plan to Improve Corporate Responsibility” 7 March, White House Press Release: retrieved on 12 June 2006 from http://www.whitehouse.gov/news/releases/2002/03/print/20020307-3.html Bush, G.W. 2002b. “President Continues Fight Against Corporate Fraud and Abuse,” 26 September, White House Press Release: retrieved on 12 June 2006 from: http://www.whitehouse.gov/news/releases/2006/09/print/20020926-10.html Bush, G.W. 2002c. “President Bush Signs Corporate Corruption Bill,” 30 July, White House Press Release: retrieved on 12 June 2006 from: http://www.whitehouse.gov/ news/releases/2006/09/print/20020926-10.html 45
  46. 46. COSO Report (Research Commissioned by the Committee of Sponsoring Organizations of the Threadway Commission). 1999. in M.S. Beasley, J.V.Carcello & D.R. Hermanson (eds), Fraudulent Financial Reporting: 1987-1997 An Analysis of US Public Companies (Jersey City, N.J.: Treadway Commission). De Fond,M., and Smith, D.B., 1991. “Discussion of the Financial Effects of the SEC Accounting & Auditing Enforcement Releases” Journal of Accounting Research Vol 29 Supplement: pp143-148. DiMaggio, P. J. and Powell, W.W., 1983, “The Iron Cage Revisited: Institutional Isomorphism and Collective Rationality in Organizational Fields,” American Sociological Review 48: 113-123. Feroz, E.H., Park,K. & Pastena,V.S., 1991. “The Financial and Market Effects of the SEC’s Accounting and Enforcement Releases, “Journal of Accounting Research, Vol 29, Supplement: pp 107-142. Kondra, A. Z. and Hinings, C.R., 1998. “Organizational Diversity and Change in Institutional Theory”, Organization Studies, 19, 5: 743-767. O’Connell,B., 2001. “An Analysis of Key Issues Arising From Professor A.J. Briloff’s Paper Entitled, “Garbage In/Garbage Out: A Critique of Fraudulent Financial Reporting: 1987-1997 (The COSO Report, 1999) The SEC Accounting Regulatory Process (AAERs)” Critical Perspectives on Accounting (2001) 12, 167-186. O’Connell,B., 2004 “Enron Inc: He That Filches From Me My Good Name…Makes me Poor Indeed,” Critical Perspectives on Accounting, 15,6-7: 733-49. O’Connell.B., Webb,L., and Schwarzback,H., 2005. “Batten Down the Hatches! U.S. Accounting Scandals and Lessons for Australia,” Australian Accounting Review Vol 15, No 2, 2005. Perell, P. M. 2006. “Deceived with Ornament: Law, Lawyers and Shakespeare’s The Merchant of Venice” Downloaded on 17 January, 2007 from: http://www.lsuc.on.ca/media/third_colloquium_paul_perell.pdf Press Release, 8 July 2005. “Federal Court Approves Dynergy Securities Fraud Settlement,” retrieved on 25 May 2006 from http://www.universityofcalifornia.edu/ news/2005/jul08C.html Rockness, H. and Rockness, J. 2005. “Legislated Ethics: From Enron to Sarbanes- Oxley, the Impact on Corporate America”, Journal of Business Ethics, Vol. 57: 31-54. Scott, W. R., 1987. “The Adolescence of Institutional Theory,” Administrative Science Quarterly 32: 493-511. 46
  47. 47. Securities and Exchange Commission (SEC). 1989. Fifty-fifth Annual Report of the SEC (Washington DC: Government Printing Office). Securities and Exchange Commission (SEC). 2002. “SEC Sues Former Tyco Director and Chairman of Compensation Committee Frank E. Walsh Jr. for Hiding $20 Million PaymentFrom Shareholders”, Press Release No. 2002-177, Retrieved on 18 January 2007 from: http://www.sec.gov/news/press/pressarchive/2002press.shtml Securities and Exchange Commission (SEC). 2003. “Commission Settles Civil Fraud Action Against Vivendi Universal, S.A., Its Former CEO, Jean-Marie Messier, and Its Former CFO, Guillaume Hannezo”, Press Release No. 2003-184, Retrieved on 18 January 2007 from: http://www.sec.gov/news/press/pressarchive/ 2003press.shtml Tabachnick, B.G. & Fidell, L.S., 2001. Using multivariate statistics. 4th.Ed., Allyn & Bacon: Boston, Mass. Weld, L.G., Bergevin,P.M., and Magrath,L. 2002. “Anatomy of a Financial Fraud, a Forensic Examination of HealthSouth,” The CPA Journal, August 2002, retrieved on 25 May 2006 http://www.nysscpa.org/printversions/cpaj/2004/1004/p44.htm Wells, J. T. 2001. “Follow fraud to the likely perpetrator”, Journal of Accountancy, New York: March, Vol. 191 ,Iss. 3: 91-4. 47

×