FRAUDULENT FINANCIAL REPORTING

The equity and credit markets (capital markets) in the United States have long been considered to be among the most efficient in the economically developed world. One reason for the efficient operation of these markets has been the public availability of creditable financial statements by those using them as a basis for their investment and credit decisions. A potential significant threat to the efficient functioning of these markets is the incidence of fraudulent financial reporting.

Fraudulent financial reporting is intentional or reckless conduct, acts, or omissions that result in materially misleading financial statements. Confidence in the operation of capital markets is compromised when the system of public disclosure is eroded by reported instances of fraudulent reporting.

In the mid-1980s the failure of a number of financial institutions led various groups to identify possible causes, including the extent of fraudulent financial reporting involved in the failures. In August 1986 Congressman John Dingell and other members of the Subcommittee on Oversight and Investigations of the U.S. House of Representatives' Committee on Energy and Commerce proposed legislation to amend the Securities Exchange Act of 1934 to require independent public accountants (auditors) to include procedures for material financial fraud detection, reporting on internal control systems, and reporting of fraudulent activities to appropriate enforcement and regulatory authorities. These legislative proposals were not accepted. The belief that the accounting profession could respond successfully without further intervention by the legislative branch of the federal government persisted.

A private-sector response to these legislative proposals was led by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission. COSO oversaw the National Commission on Fraudulent Financial Reporting (the Treadway Commission). This commission, jointly sponsored and funded by the American Institute of Certified Public Accountants (AICPA), the American Accounting Association, Financial Executives International, the Institute of Internal Auditors, and the National Association of Accountants (now the Institute of Management Accountants), was formed to identify factors contributing to fraudulent financial reporting and to develop recommendations to reduce its future occurrence. The Treadway Commission issued its report in October 1987.

TREADWAY COMMISSION REPORT

The Treadway Commission concluded that the responsibility for fraudulent financial reporting was not vested in one group. While the commission conceded that financial statements are the responsibility of a company's management, it issued a series of recommendations for the public company, the independent public accountant, the Securities and Exchange Commission (SEC), and the educational community.

The report identified a number of factors that might contribute to fraudulent financial reporting, including a number of environmental, institutional, and individual personal incentives. Environmental considerations included professionalism, codes of corporate conduct, and corporate pressures. Institutional incentives include falsely improving financial appearances in financial statements for the purpose of maintaining market stock prices or to meet investor expectations, as well as delaying the reporting of financial difficulties in order to avoid failure to comply with covenants in debt agreements. Individual incentives include falsely reporting results in order to achieve targeted results for bonus or incentive compensation purposes, as well as to avoid penalties for poor performance in achieving targeted profit objectives.

The Treadway Commission indicated that the over sight bodies that establish auditing standards and those which monitor compliance have a continuing responsibility to uphold the integrity of the public disclosure system. The commission also concluded that many of the SEC's fraudulent financial reporting cases against auditors were for alleged failures to conduct the audits in accordance with generally accepted auditing standards.

RESPONSE OF THE AUDITING STANDARDS BOARD

In response to the Treadway Commission report and to other influences, the Auditing Standards Board (ASB) of the AICPA issued ten new auditing standards in 1988. These ten Statements on Auditing Standards included requirements affecting the auditor's responsibility to detect and report errors and irregularities, consideration of internal control structure in a financial statement audit, and communication with a company's audit committee.

CONTINUING ATTENTION TO THE PROBLEMS IN THE 1990S

Continuing attempts were made to gain an understanding of fraudulent financial reporting in the 1990s. The influence of the Treadway Commission report persisted. Several reports received serious consideration throughout the reporting environment. Nevertheless, in this decade no changes related to auditor responsibility for reporting about internal controls if fraud was to be deterred were considered critical. Internal controls continued to be evaluated in the context of planning an audit of financial statements, but the results of the assessment of internal controls and their effectiveness were not reported publicly.

INTERNAL CONTROL

In 1992 COSO issued Internal Control—An Integrated Framework for companies, their managements, and their auditors. The framework is a conceptual paradigm that provides subjective concepts of effective internal control. COSO defined internal control as a process designed by a company's management to provide reasonable assurance that the company achieve its objectives in the following areas:

• Reliability of financial reporting
• Compliance with applicable laws and regulations
• Effectiveness and efficiency of operations

The COSO framework identified five interrelated components of internal control:

1. The control environment that sets the tone of an organization
2. Risk assessment that identifies and analyzes potential risks
3. Control activities that are policies and procedures to ensure that management objectives are carried out
4. Information and communication that identify and process information which enable people to carry out responsibilities
5. Monitoring that assesses compliance with control procedures

The framework provides only reasonable assurance because there are inherent limitations in any system of internal control.

STUDY OF SEC ACCOUNTING AND ENFORCEMENT RELEASES

In 1999 COSO issued the results of a study of SEC accounting and enforcement releases between 1987 and 1997. This study attempted to gain an understanding of the participants and the extent and duration of fraudulent behavior. Because of the limitations of the study, the usefulness of the findings were at best tentative and primarily suggestive of the nature of the behavior of auditors and company officials.

BLUE RIBBON COMMITTEE REPORT

At the request of the SEC chairman, the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) formed the Blue Ribbon Committee, which was charged with recommending ways to enhance the effectiveness of audit committees. The Blue Ribbon Committee, in its 1999 report, Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees, which was addressed to the heads of the two sponsoring organizations—NYSE and NASD—recommended stronger audit committee oversight responsibilities relating to financial reporting. Among the recommendations were the clarification of the relationship of the external auditor with management and the audit committee, improvement in oversights of the financial reporting process, and enhancing communications about accounting reporting processes between the external auditor and the audit committee.

CORPORATE SCANDALS AND THE SARBANES-OXLEY ACT

A series of business failures and financial scandals that began with Enron's disclosures of fraudulent behavior in second half of 2001 caused a serious decline in investor confidence in the capital markets. In an attempt to restore public investor confidence, the federal government passed the Sarbanes-Oxley Act of 2002, which amended the Securities Exchange Act of 1934 and expanded rules concerning corporate governance. Sarbanes-Oxley improved the oversight of external auditors and focused the attention of companies and auditors on internal control; it also increased penalties for noncompliance. The intent of these elements of Sarbanes-Oxley is to reduce the likelihood that material fraud will go undetected.

The Sarbanes-Oxley Act includes the following major provisions affecting both management and external auditors:

• The creation of the Public Companies Accounting Oversight Board (PCAOB)
• Rules designed to increase auditor independence
• New responsibilities for corporate directors, chief executive officers, and chief financial officers
• Enhanced financial disclosures

The PCAOB is a five-member board of financially literate members. The board has the authority to establish auditing standards, quality control standards, and independence standards for audits of public companies. In addition, the PCAOB has the authority to inspect the work of public company auditors. The PCAOB's deliberations result in the adoption of rules that are submitted to the SEC for approval. Prior to Sarbanes-Oxley, the AICPA's ASB was responsible for many of these functions on a self-regulatory basis.

The Sarbanes-Oxley Act strengthened auditor independence by making it unlawful for an auditor to perform audit services for a public company and to also perform nonattest services such as bookkeeping and other consultative services for the same audit client.

The Sarbanes-Oxley Act increased penalties imposed on the managements of public companies found to be responsible for false and misleading financial statements. Included in the act is a provision requiring a public company's chief executive officer and chief financial officer to certify the appropriateness of the financial statements and disclosures contained in the company's annual report.

Section 404 of the Sarbanes-Oxley Act and Auditing Standard No. 2 issued by the PCAOB require corporate management and the company's independent auditor to issue two reports that must be included in the company's annual report filed with the SEC. These two reports require management and the independent auditor of public companies to assess and report on the effectiveness of the company's internal control over financial reporting. Management must state in its report its responsibility for maintaining adequate internal control over financial reporting and give its assessment of whether or not internal control over financial reporting is effective or not.

The independent auditor must evaluate and report on the fairness of management's assessment. The auditor will also perform an independent audit of internal control over financial reporting and will issue an opinion on whether internal control is operating as of the assessment date. If one or more material weaknesses exist at the company's fiscal year-end, the auditor cannot conclude that internal control over financial reporting is effective.

The purpose of these reporting requirements is to increase the likelihood that material weaknesses in internal control over financial reporting will be identified and remediated.

Despite these requirements, it is still possible for fraudulent financial reporting to occur. Although the intended results of internal control reporting is to reduce the likelihood that material fraud will go undetected, no system of internal control provides absolute assurance that manipulation, collusion, or management override will not occur.

see also Auditing; Forensic Accounting

bibliography

Blue Ribbon Committee. (1999). Improving the effectiveness of corporate audit committees: Report and recommendations of the Blue Ribbon Committee on improving the effectiveness of corporate audit committees. New York: New York Stock Exchange; Washington, DC: National Association of Securities Dealers.

Committee of Sponsoring Organizations of the Treadway Commission. (1992). Internal control—Integrated framework. New York: Author.

Committee of Sponsoring Organizations of the Treadway Commission. (1999). Fraudulent financial reporting: 1987–1997: An analysis of U.S. public companies. Retrieved January 13, 2006, from http://www.coso.org/Publications.htm

National Commission on Fraudulent Financial Reporting. (1987). Report of the National Commission on Fraudulent Financial Reporting. Washington, DC: Author.

Public Company Accounting Oversight Board. (2004, June 17). Auditing Standard No. 2: An audit of internal control over financial reporting performed in conjunction with an audit of financial statements. Retrieved January 13, 2006, from http://www.pcaobus.org/Standards/Standards_and_Related_Rules/Auditing_Standard_No.2.asp

Whittington, Ray, and Pany, Kurt (2006). Principles of auditing and other assurance services (15th ed.). Boston: McGraw-Hill/Irwin.

Gerard A. Lange