Focus on Fraud: COSO Fraudulent Financial Reporting Study

“The audit committee’s oversight responsibility for financial reporting risks transcends most enterprise risks faced by the organization. A financial reporting failure due to fraud often adversely impacts reputation, employee morale and the ability to achieve strategic objectives.”

-Glenn Pomerantz, Partner, BDO Consulting

In February 2010, COSO issued Fraudulent Financial Reporting: 1998-2007, a report1 which provided a comprehensive analysis of fraudulent financial reporting investigated by the SEC between January 1998 and December 2007. The study reviewed certain key organization and management characteristics involved in instances of financial reporting fraud identified in SEC Accounting and Auditing Enforcement Releases (AAERs) and compared these organizations to a non-fraud control group. The study further provided insights related to preventing, deterring and detecting fraudulent financial reporting.

The report contains some interesting overall findings: Compared to the previous study conducted by COSO, which covered the period from 1987-1997, the number of alleged cases of financial reporting fraud increased from 294 to 347, an increase of approximately 18 percent. The median fraud of $12 million in the recent study compares to a median fraud of $4 million in the previous study. Organizations allegedly engaging in fraudulent financial reporting (which included start-ups through established organizations) had median assets and revenues of just under $100 million compared to $15 million reported previously. These facts seem to indicate that the frequency of fraud is increasing; the size of the impact of fraud is increasing; and the size of the organizations involved in alleged financial reporting fraud is also increasing. Improper revenue recognition continued to be the leading method of perpetrating financial reporting fraud within 61 percent of the cases (up from 50 percent of the cases in the previous study). No particular industry dominated the organizations that experienced financial reporting fraud, however, “computer hardware/software” organizations and “other manufacturing” organizations each represented approximately 20 percent of the organizations identified in the study. The exchanges on which organizations that allegedly engaged in financial reporting fraud were traded also provide interesting information. Approximately 50 percent of the “fraud” organizations in the current study were traded on NASDAQ. However, only approximately 24 percent of all publicly traded organizations are registered on NASDAQ, which indicates a higher proportion of organizations experiencing financial reporting fraud are traded on this exchange.

For a statistically significant number of cases of fraud noted in the COSO study, the organization had been experiencing financial difficulties. In the majority of the cases, senior management was involved in the fraud and, specifically, in 89 percent of cases, the AAERs named the CEO and/or CFO as being associated with the financial statement fraud. The most commonly cited motivations for fraud included the need/desire to: meet earnings expectations, conceal deteriorating financial condition, increase stock price, bolster financial performance for pending financings, increase compensation based on financial results, and cover up asset misappropriation. Other “red flags” highlighted in the report for fraud organizations as compared to the non-fraud control group included higher rate of related party transactions and higher rate of change in external auditors.

BDO notes the key takeaway from this report for all audit committees is the need to remain vigilant – be mindful of fraud risk factors, financial stress/pressures and other motivators of fraud, management’s tone at the top, etc. – and be willing to challenge management with respect to fraud.

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(1) Refer to COSO “Fraudulent Financial Reporting: 1998-2007 – An Analysis of U.S. Public Companies”