Shows Fraud Networks Led by CEOs and Aided by Company Outsiders
JUNE 2007 -
A study funded by a grant from the Institute for Fraud Prevention
concludes that the overrides of internal controls leading to financial
statement fraud are typically caused by a fraud network led by the
CEO and aided by individuals from outside of the company. These
fraud networks cause extremely large losses, and the study found
that these losses are far greater when the outside audit firm has
aided the fraud.
study involved a review of 834 companies that filed financial
restatements between 1997 and 2002. By examining these restatements,
along with any class action lawsuits and SEC proceedings taken
against the companies, the researchers, Robert Tillman and Michael
Indergaard of St. John’s University in New York, were able
to extrapolate several trends in financial statement fraud.
the study’s conclusions corroborate findings from other
research, including the following: Investor losses from financial
statement fraud are of devastating proportions. The most expensive
frauds are almost invariably led by controlling persons, typically
the CEO. (Criminologists refer to these as “control frauds.”)
The CEO normally includes the CFO in the fraud network. Restatements
are more common in so-called “New Economy” industries,
such as information technology, energy trading, and telecommunications.
The data also revealed previously underexplored facets of financial
to the findings was evidence that these schemes are rarely solitary
endeavors. The average number of parties connected with the alleged
fraud cases studied was 7.2. Additionally, in more than half of
the schemes examined, a company other than the restating organization—usually
an investment bank, auditing firm, or colluding business partner—was
implicated as a participant. One striking finding was that average
shareholder losses were more than twice as large in cases in which
it was alleged that the outside audit firm aided the control fraud.
The IFP reports
that its study adds important insights to prior research by the
Treadway Commission, which also found that control frauds dominated
financial statement frauds. But the commission examined a biased
sample of cases. The financial statement frauds it studied were
overwhelmingly very small corporations using smaller audit firms.
Treadway assumed that the problem was limited to smaller corporations
with weaker internal controls and lower-tier auditors. Tillman’s
research for IFP found that corporations of all sizes were roughly
as likely to engage in financial statement fraud and that large
“control frauds” were able to defeat sophisticated
internal controls and enlist top-tier audit firms to aid their
frauds. Indeed, the study found that large control frauds caused
a grossly disproportionate share of the total direct losses to
The IFP researchers
also selected a subsample of 17 restatements for further examination.
These deeper analyses of SEC documents and class-action suits
shed light on additional details of the schemes and enabled classification
by types of fraud and responses by senior management and auditors.
Both portions of the study emphasize the involvement of numerous
individuals—both internal and external to the perpetrating
organization—in the cases examined. Many schemes are facilitated
by a “network of fraud” that overrides internal controls
already in place. The case studies confirmed that CEOs frequently
created and led the control fraud networks that produced financial
statement fraud. Neither the board of directors nor the outside
auditor proved effective in restraining control fraud.
primary policy recommendation arising from their research findings
is continued oversight of the financial reporting process and
the maintenance of policies that require accountability on the
part of senior managers, board members, and auditors. Their specific
recommendations include the following:
- A requirement
that CEOs and CFOs certify reports to shareholders, as mandated
by the Sarbanes-Oxley Act, should be maintained, given these
individuals’ central role in financial fraud.
securities fraud suits remain a vital mechanism for detecting
and remedying financial statement fraud. The SEC is able to
act against only a minority of likely financial statement frauds.
their significant involvement in financial statement fraud,
the measures designed to limit the liability of auditing firms
should be opposed.
to reduce corporate board members’ liability for financial
statement fraud would harm deterrence.
study is available for download at www.theifp.org.
The IFP, a consortium of universities dedicated to researching
the causes of fraud and how to reduce it, is a partnership of
the Association of Certified Fraud Examiners (ACFE), the AICPA,
and government, academic, public, and private organizations.
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