The RMC Advisors

Fraudulent Financial Reporting - Time to Learn from the Past

In the coming decade, will history repeat itself or will we learn from the past? This year the Committee of Sponsoring Organizations of the Treadway Commission (COSO) released their second report on fraudulent financial reporting. This report covers the years from 1998 – 2007.  Their previous 1999 report covered the years 1987 - 1997.

 What have we learned?

 The findings are not very encouraging. Fraud is even more prevalent in the past ten years than the prior 10 years. The 2010 report identified 347 cases of fraud compared to 294 cases of public companies reporting fraud in the 1999 report. In addition, the mean fraud rose from $4.1 million in the 1999 study to $12.05 million in the 2010 study. In the years 1998 through 2007, there was nearly $120 billion in known misstatements or misappropriations. Since the 2010 report only included a limited number of cases after the implementation of the Sarbanes-Oxley (SOX) legislation, it is too early to assess the effect of SOX on addressing fraud.

 What can we do?

 Pay Attention to the C-Suite: Accounting and Auditing Enforcement Releases (AAER) from the Securities and Exchange Commission (SEC) named the CEO and/or CFO as defendants in 90% of the cases in the years 1998-2007. Boards and auditors need to be ever vigilant to the red flags of fraud and should understand what drives the CEO or the CFO to commit financial statement fraud. It is important boards and auditors work to reduce incentives and pressures on management to commit financial statement fraud.

 Look for Revenue Fraud: Over 60 % of the fraud cases in the 2010 report involved revenue fraud. A look at the stock graphs for WorldCom and Enron provide a picture of a company in trouble and the ultimate results. Industry specific studies are important ways to identify overstatement of revenues. The Board and the auditors must find ways to identify and investigate potential overstatement of revenue before it becomes an SEC issue or a major fraud.

 Board Governance: The 2010 report does not identify differences in governance characteristics between companies with fraud and those without. According to COSO, this area requires additional research. Does your management and board have an attitude of transparency and the desire to have all information, good and bad, out in the open? If not, you may want to take steps to develop this attitude. In addition, check out the article on Strengthening Enterprise Risk Management within the context of the risk related to management compensation and the pressure to meet the financial expectations.

 Change of Auditors: COSO determined that there is a trend for companies to change auditors between clean and fraudulent financial statements. This puts an extra burden on the Financial Auditors to look into prior years to compare the financials to the year under review and note any unexplainable discrepancies.

 Consequences: The severe consequences of fraud are well publicized. These include sanctions against individuals and companies. This frequently includes jail time and restitution judgments against the perpetrators. There is significant negative impact to the shareholders including bankruptcy, abnormal stock declines and job losses.

 Though greed appears to have increased over the past two decades, the time is right for boards and auditors to take this trend seriously and recognize that everyone is a potential candidate to commit fraud. Learn the red flags of fraud and never be afraid to ask the hard questions and get the right answers. Dig deeper and do not accept a cursory response; the hard question may be the best question you ever asked.

 The entire 2010 report by COSO, Fraudulent Financial Reporting 1998 – 2007 is located at http://www.coso.org/documents/COSOFRAUDSTUDY2010.pdf

 For a copy of the fraud checklist, contact Elaine Nissley at ENissley@macpas.com.

 

SEC Delays Section 404(b)

After months of delay, the SEC finally released the results of its Sarbanes-Oxley Section 404 implementation cost-benefit analysis.  The report states small businesses must comply with 404(b) after one last extension.  On October 2, 2009, the SEC implemented what they say is the final extension to meeting this deadline.  “Since there will be no further Commission extensions, it is important for all public companies and their auditors to act with deliberate speed to move toward full Section 404 compliance.”  - Mary L. Schapiro, SEC Chairman.  

The SEC provides examples of how this plan will be cost effective for small business by implementing Auditing Standard No. 5 in place of Auditing Standard No.2.  Per the final ruling located  on the SEC website (www.SEC.gov).