Accounting fraud usually starts at the top of the corporate ladder, but its effects filter all the way back down.
Dana Hermanson, Dinos Eminent Scholar of Private Enterprise and accounting professor at Kennesaw State University’s Coles College of Business, said a recent 10-year study from the Treadway Commission found that in 90 percent of the 347 cases of alleged fraudulent reporting it identified in public companies from 1998-2007, CEOs and CFOs were implicated in the U.S. SEcurities and Exchange Commission investigations.
“But that’s only the beginning of the consequences," said Hermanson, co-author of the study. "The repercussions go on to affect employees, stockholders and board members.”
Hermanson compared companies investigated for fraud with those that were not.
“We found that the companies under investigation for accounting fraud had abnormal stock declines (an average of 17 percent) within two days of the fraud announcement,” he said. “Twenty-eight percent of the alleged fraud companies went bankrupt and 62 percent had to liquidate assets within two years, and 47 percent of these companies were de-listed from a stock exchange, which impacted both the company’s reputation and access to capital.”
The Treadway Commission has published fraudulent accounting data studies for three decades in an effort to better understand and to help reduce corporate accounting fraud.
The latest study showed a spike in money involved in the cases.
“There were 347 cases in 1998-2007 versus 294 cases in 1987-1997, but the dollar amount soared to nearly $400 million per case. By comparison, the mean was $25 million per case in the decade before,” Hermanson said. The latest decade included the dot.com bust of 2001, and the high-profile fraud cases of Enron, Tyco International and WorldCom.
“There is fraud against the company for personal gain, such as embezzlement," Hermanson said. "Then there is fraud on behalf of the company. Someone adjusts the accounting to make the company performance look better. We studied the second kind.”
Sometimes fraudulent accounting begins with good intentions, but the results generally backfire.
“Fraudulent reporting often starts small, and can start with someone who has a good motive,” said Dennis Beresford, Ernst & Young Executive Professor of Accounting at the University of Georgia’s Terry College of Business. “Maybe the person sees the company having temporary problems and wants to help it through a bad patch, so he doesn’t record a loss, or shifts future sales into the present quarter. He may think he’s avoiding the bank calling in a loan or having to lay off employees. When things don’t get better in the next quarter, he has to keep making up numbers and eventually gets caught. Then the fallout hits everyone.”
Pressure to make earnings projections can lead to fraudulent behavior, as can the payoffs of higher stock prices and options and executives getting to hit bonus pay targets.
“Missing a projected earnings report by one penny can cause stock prices to drop $10 a share,” Beresford said. “Companies try hard to be successful, but they need to do it by legitimate means.”
Beresford said he is encouraged that there haven’t been more "gargantuan" frauds like Enron and WorldCom lately. He attributes that, in part, to the Sarbanes-Oxley Act of 2002.
“After Enron, there were congressional hearings but no move to legislation. When WorldCom hit in June of 2002, it was the straw that broke the camel’s back. Within a month, Congress had passed Sarbanes-Oxley to set new financial standards and regulations,” Beresford said. “Now we’re seeing people pay more attention to company records and auditors doing their jobs better. We have better tools all the time to detect fraud and whistle-blower provisions.”
The main lessons to be learned from corporate fraud are that it hurts everyone and that people in the trenches need to speak up, Beresford said. “With WorldCom, there were managers who could see something wasn’t right, but they figured the CFO knew more than they did and didn’t say anything.”
Paying attention to company culture is one of the best ways to prevent fraud, Hermanson said. “A ‘make the numbers or you're out the door’ approach to sales, huge rewards for making targets, an attitude of never missing projections, or management seeing Sarbanes-Oxley as a waste of time, could be signs of an unhealthy culture,” he said. “Always be skeptical. If someone asks you to do something that doesn’t make sense, question it.”
“Standing up and challenging bad behavior takes courage,” Beresford said, “but it has to be done.”
