1.4 Statistics

It is difficult to know how much financial statement fraud exists. Probably the best measure of the amount of financial statement fraud is to look at SEC enforcement releases (AAERs). One or more enforcement release is typically issued when financial statement fraud occurs at a company whose stock is publicly traded.

While several studies have examined AAERs, the most comprehensive study was commissioned by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and was conducted by Beasley, Carcello, Hermanson, and Neal. In the study, all financial statement frauds from 1998 to 2007 were analyzed. The results of this study were published in early 2010. The most recent study suggests that:

• Of the 347 alleged cases of public company fraudulent financial reporting, the median financial statement fraud was $12.05 million.

• Organizations that were involved in fraudulent financial reporting had assets and revenues of just under $100 million.

• In 89% of the cases, the CEO and/or CFO was named in the AAER for some level of involvement in the fraud. Within two years of the completion of the investigation, 20% of the CEOs/CFOs were indicted and over 60% of those indicted had been convicted.

• The most common techniques used to manipulate financial statements were improper revenue recognition, followed by overstatement of existing assets or capitalization of expenses. Collaborating studies have suggested similar results.

• Twenty-six percent of the fraud firms changed auditors between the last clean financial statements and the last fraudulent financial statements, whereas only 12% of no-fraud firms switched auditors during that same period. Sixty percent of the fraud firms that changed auditors did so during the fraud period, while the remaining 40% changed auditors in the fiscal period prior to the fraud.

• Once the news of an alleged fraud reached the press, company stock declined, on average, 16.7%. Furthermore, news of an SEC or Department of Justice investigation resulted in a roughly 7.3% abnormal stock price decline.

• Consequences associated with financial statement fraud were severe for both the companies and individuals involved. Companies engaged in fraud often experienced bankruptcy, delisting from stock exchanges, and/or material assets sales following the discovery of the fraud.

These findings are consistent with other similar reports such as the Report Pursuant to Section 704 of the Sarbanes-Oxley Act of 2002 prepared by the SEC. Section 704 of the Sarbanes-Oxley Act required the Securities and Exchange Commission to review and analyze all enforcement actions by the SEC involving violations of reporting requirements imposed under the securities laws, and restatements of financial statements, over the five-year period preceding the date of enactment of the Act, to identify areas of reporting that are most susceptible to fraud, inappropriate manipulation, or inappropriate earnings management, such as revenue recognition and the accounting treatment of off-balance-sheet special purpose entities. Section 704 also required the Commission to report its findings to the Committee on Financial Services of the House of Representatives and the Committee on Banking, Housing and Urban Affairs of the Senate, not later than 180 days after the date of the enactment of the Act and to use its findings to revise its rules and regulations as necessary.

In fulfilling this requirement, the Commission staff reviewed and analyzed the actions filed by the Commission during the period July 31, 1997 through June 30, 2002. During that period, the Commission filed 515 enforcement actions for financial reporting and disclosure violations arising out of 227 Division of Enforcement investigations. The 515 actions included 869 named parties, consisting of 164 entities and 705 individuals. During the five-year period, the number of enforcement actions involving issuer financial reporting violations of fraud increased from 91 in the first year of the study to 149 in the last year of the study. The number of cases each year was as follows:

The study, like previous studies, found that the Commission brought the greatest number of actions in the area of improper revenue recognition: 126 of the 227 enforcement matters involved such conduct, including the fraudulent reporting of fictitious sales, improper timing of revenue recognition, and improper valuation of revenue. One hundred one enforcement matters involved improper expense recognition, including improper capitalization or deferral of expenses, improper use of reserves and other understatement of expenses. Additionally, 23 enforcement matters involved improper accounting for business combinations. One hundred thirty-seven enforcement matters involved other accounting combinations. One hundred thirty-seven enforcement matters involved other accounting and reporting issues such as inadequate Management Discussion and Analysis disclosures and improper use of off-balance-sheet arrangements.

The specific types of financial statement fraud found in the enforcement releases are shown in the following table:

Like other studies, the SEC study revealed that the majority of the persons held responsible for the accounting violations were members of senior management. The study found that 157 of the 227 enforcement matters involved charges against at least one senior manager. In these enforcement matters, charges were brought against 75 Chairmen of the Board, 111 Chief Executive Officers, 111 Presidents, 105 Chief Financial Officers, 21 Chief Operating Officers, 16 Chief Accounting Officers, and 27 Vice Presidents of Finance.

Some of the cases that occurred between 1997 and 2002 included Enron, WorldCom, Adelphia, Home Store, Cendant, Qwest, Xerox, Sunbeam, and Waste Management. Many of these frauds have led to huge bankruptcies, the loss of investor confidence, and the loss of trillions of dollars in market value. In fact, two of the five largest bankruptcies in history included WorldCom and Enron, both companies that were involved in large-scale financial statement frauds. Unfortunately, when a company perpetrates financial statement fraud, the market value of that company's stock usually declines much more than the amount of the fraud. Table 1.1 shows the ten largest bankruptcies since 1980. Three of these (WorldCom, Enron, and Conseco) all involved financial statement fraud.