Study Shows Fraud Networks Led by CEOs and Aided by Company Outsiders

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JUNE 2007 - A study funded by a grant from the Institute for Fraud Prevention (IFP, 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.

The 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.

Several of 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 statement fraud.

Paramount 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 shareholders.

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.

The authors’ 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.
  • Class-action 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.
  • Given their significant involvement in financial statement fraud, the measures designed to limit the liability of auditing firms should be opposed.
  • Attempts to reduce corporate board members’ liability for financial statement fraud would harm deterrence.

The full study is available for download at 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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