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Critical Perspectives on Accounting 16 (2005) 277–298 Causes, consequences, and deterence of financial statement fraud Zabihollah Rezaee∗ Fogelman College of Business and Economics, 300 Fogelman College Admin. Building, The University of Memphis, Memphis, TN 38152-3120, USA Received 15 June 2002; received in revised form 11 November 2002; accepted 15 December 2002 Abstract Financial statement fraud (FSF) has cost market participants, including investors, creditors, pen- sioners, and employees, more than $500 billion during the past several years. Capital market par- ticipants expect vigilant and active corporate governance to ensure the integrity, transparency, and quality of financial information. Financial statement fraud is a serious threat to market participants’ confidence in published audited financial statements. Financial statement fraud has recently received considerable attention from the business community, accounting profession, academicians, and reg- ulators. This article (1) defines financial statement fraud; (2) presents a profile of financial statement fraud by reviewing a selective sample of alleged financial statement fraud cases; (3) demonstrates that “cooking the books” causes financial statement fraud and results in a crime; and (4) presents fraud prevention and detection strategies in reducing financial statement fraud incidents. Financial statement fraud continues to be a concern in the business community and the accounting profession as indicated by recent Securities and Exchange Commission (SEC) enforcement actions and the Corpo- rate Fraud Task Force report. This paper sheds light on the factors that may increase the likelihood of financial statement fraud. This paper should increase corporate governance participants’ (the board of directors, audit committees, top management team, internal auditors, external auditors, and governing bodies) attention toward financial statement fraud and their strategies for its prevention and detection. The Sarbanes-Oxley Act of 2002 was enacted to improve corporate governance, quality of financial reports, and credibility of audit functions. The Act establishes a new regulatory framework for public accountants who audit public companies, creates more accountability for public companies and their executives, and increases criminal penalties for violations of securities and other applicable laws and regulations. Given the difficulties and costs associated with deterring financial statement fraud, un- derstanding the interactive factors described in this article (Cooks, Recipes, Incentives, Monitoring ∗ Tel.: +1-901-678-4652; fax: +1-901-678-0717. E-mail address: zrezaee@memphis.edu (Z. Rezaee). 1045-2354/$ – see front matter © 2003 Elsevier Ltd. All rights reserved. doi:10.1016/S1045-2354(03)00072-8 278 Z. Rezaee / Critical Perspectives on Accounting 16 (2005) 277–298 and End-Results (CRIME)) that can influence fraud occurrence, detection and prevention is relevant to accounting and auditing research. © 2003 Elsevier Ltd. All rights reserved. Keywords: Financial statement fraud; Corporate governance; Sarbanes-Oxley Act of 2002; Cooking the books; Fraud prevention and detection strategies 1. Introduction Financial statement fraud (FSF) has received considerable attention from the public, press, investors, the financial community, and regulators because of high profile reported fraud at large companies such as Lucent, Xerox, Rite Aid, Cendant, Sunbeam, Waste Management, Enron Corporation, Global Crossing, WorldCom, Adelphia, and Tyco. The top executives of these and other corporations were accused of cooking the books and, in many cases, were indicted and subsequently convicted. The collapse of Enron has caused about $70 billion lost in market capitalization which is devastating for significant numbers of investors, employees and pensioners. The WorldCom collapse, caused by alleged financial statement fraud, is the biggest bankruptcy in the United States history. Loss of market capitalization resulting from the reported financial statement fraud committed by Enron, WorldCom, Qwest, Tyco, and Global Crossing is estimated about $460 billion (Cotton, 2002). These and other corporate scandals have raised three important questions of (1) how severe is corporate misconduct in the United States, (2) can corporate financial statements be trusted, and (3) where were the auditors? It is trusted that the majority of publicly traded companies in the United States have a responsible corporate governance, a reliable financial reporting process, effective audit functions, conduct their business in an ethical and legal manner, and through continuous improvements enhance their earnings quality and quantity. Nevertheless, the pervasiveness of reported financial statement frauds caused by “cooking the books” and related alleged audit failures have eroded the public confidence in corporate America. The reliability, transparency, and uniformity of the financial reporting process allow in- vestors to make intelligent decisions. Published audited financial statements that reflect a true and honest financial performance instead of a rosy picture and inflated and fraudu- lent earnings are useful to market participants, including investors and creditors. Enron, WorldCom, and other corporate scandals, earnings restatements, customized and managed pro forma earnings have undermined investors’ confidence in the quality and reliability of the financial system. Capital markets participants (e.g. investors, creditors, analysts) make investment decisions based on financial information disseminated to the market by corporations. Thus, the quality, reliability, and transparency of published audited financial statements are essential to the efficient allocation of resources in the economy. Auditors lend creditability to the information disclosed in a firm’s financial statements by reducing the risk that the information is materially misstated. The importance of financial information to the efficiency of securities markets is repeatedly noted in speeches given by Securities and Exchange Commission (SEC) commissioners. For example, “Audited financial state- ments provide the foundation for our securities markets. Audited financial statements allow investors to make decisions on whether to buy, hold, or sell a particular security” (SEC, Z. Rezaee / Critical Perspectives on Accounting 16 (2005) 277–298 279 2002a). “Accurate information also improves the quality of markets by allowing markets to discover the true price at which specific securities trade” (SEC, 2002b). Market participants assess lower information risk associated with high-quality financial reports. This lower perceived information risk will make capital markets more efficient, induce lower cost of capital and higher securities prices. Thus, the society, business com- munity, accounting profession, and regulators have a vested interest in the prevention and detection of financial statement fraud because its occurrences undermine the confidence in corporate America. This article (1) defines financial statement fraud; (2) presents a profile of financial statement fraud by reviewing a selective sample of reported financial statement fraud cases; (3) demonstrates that “cooking the books” causes financial statement fraud and results in a crime; and (4) presents fraud prevention and detection strategies in reducing financial statement fraud incidents. 2. Financial statement fraud Financial statement fraud is a deliberate attempt by corporations to deceive or mislead users of published financial statements, especially investors and creditors, by preparing and disseminating materially misstated financial statements. Financial statement fraud involves intent and deception by a clever team of knowledgeable perpetrators (e.g. top executives, auditors) with a set of well-planned schemes and a considerable gamesmanship. Financial statement fraud may involve the following schemes (1) falsification, alteration, or manipu- lation of material financial records, supporting documents, or business transactions; (2) ma- terial intentional misstatements, omissions, or misrepresentations of events, transactions, accounts or other significant information from which financial statements are prepared; (3) deliberate misapplication, intentional misinterpretation, and wrongful execution of ac- counting standards, principles, policies and methods used to measure, recognize, and report economic events and business transactions; (4) intentional omissions and disclosures or pre- sentation of inadequate disclosures regarding accounting standards, principles, practices, and related financial information; (5) the use of aggressive accounting techniques through illegitimate earnings management; and (6) manipulation of accounting practices under the existing rules-based accounting standards which have become too detailed and too easy to circumvent and contain loopholes that allow companies to hide the economic substance of their performance. 3. Profile of financial statement fraud Financial statement fraud has cost investors more than $500 billion during the past several years (Rezaee, 2002; Cotton, 2002). Financial statement fraud committed by Enron is esti- mated to cause a loss of about $70 billion in market capitalization to investors, employees and pensioners who held the company’s stock in their retirement accounts. The US General Accounting Office (GAO) released a report in October 2002, which indicates that the num- ber of restatements due to accounting irregularities has grown significantly during the past several years. The GAO study reports about 10% of all listed companies announced at least 280 Z. Rezaee / Critical Perspectives on Accounting 16 (2005) 277–298 one restatement between January 1997 and 30 June 2002 which represent a 145% growth rate during this time period and is expected to grow to 170% by the end of year 2002 (GAO, 2002). Table 1 summarizes a sample of the most recent high profile alleged financial state- ment fraud cases, including Enron, WorldCom, and Global Crossing.1 A thorough review of these cases determines that five interactive factors explain and justify the occurrences of these high profile alleged financial statement frauds. These interactive factors are referred to as cooks, recipes, incentives, monitoring, and end results, with the abbreviation of CRIME (Rezaee, 2002). The right combination of these factors is a prerequisite for the commission of financial statement fraud as discussed in the following pages. This schema of “five interactive factors” encapsulated in the acronym CRIME provides several contributions. First, it increases the understanding of financial statement fraud by focusing on five interactive factors that explain causes and effects of financial statement fraud. Second, it emphasizes the importance of vigilant and effective corporate governance participants including the board of directors, the audit committee, management, internal au- ditors, external auditors, and governing bodies (e.g. Securities and Exchange Commission, SEC, American Institute of Certified Public Accountants, AICPA) can play in preventing and detecting financial statement fraud. Finally, it suggests fraud prevention and detec- tion strategies by presenting new initiatives taken by Congress (e.g. Sarbanes-Oxley Act of 2002), regulators (e.g. SEC certification requirements, and accelerated filing deadlines) and the accounting profession (e.g. AICPA’s six leadership roles) in an attempt to improve corporate governance, quality of financial reports, credibility of audits and reduce financial statement fraud incidents. 3.1. Cooks The first letter in the word “CRIME” is “C,” which stands for “COOKS.” The GAO report (2002) indicates that almost 75% of the total 150 accounting-related SEC cases brought from January 2001 to February 2002 were against public companies or their directors, officers, and employees whereas the other 25% involved accounting firms and CPAs. Financial statement fraud cases presented in Table 1 and the results of the 1999 COSO Report (Beasley et al., 1999) reveal that in the majority of these cases (more than 80%), the chief executive officer (CEO) and/or chief financial officers (CFOs) were associated with financial statement fraud. Other individuals typically involved with financial statement fraud are controllers, chief operation officers, board of director members, other senior vice presidents, and both internal and external auditors. A majority of financial statement frauds occur with participation, encouragement, approval, and knowledge of top management teams including CEOs, CFOs, presidents, treasurers, and controllers. A consensus may be emerging that financial statement fraud is more often the result of actions or inactions, deliberate or inadvertent, by the top management team of publicly traded companies. This has been used as a basis and rationale for holding company officials personally responsible for occurrences of financial statement fraud, liable for resulting losses, and subject to fines as well as potential incarceration. There are also numerous instances of fraud at the subsidiary or divisional level that do not 1 Due to the space constraints, only a limited number of the reported financial statement fraud cases are sum- marized in Table 1. A more comprehensive list of these and other cases is available upon request from the author. Z.Rezaee/CriticalP e rspectives o n Accounting 16(2005)277–298 281 Table 1 Sample of financial statement fraud cases Company Cooks Recipes Incentives Monitoring End results (consequences) Aurora Foods, Inc. CFO, CEO, senior financial analysts, manager of customer financial services Overstating reported earnings, understating trade marketing expenses Meet analysts’ forecasts by inflating the company’s financial results to raise funds in an IPO Lack of vigilant board of directors and audit committee; lack of diligent management Repayment of bonuses of the executives, barring the executives from serving as officers or directors of a public company, and substantial reduction in price of stock Cendant Corporation Three former top executives Earnings management by overstating revenue by $500 million between 1995 and 1997 Sell CUC and Cendant stock at inflated prices Lack of responsible corporate governance and ineffective audit functions Cost more than $15 billion in market capitalization and lawsuits against the accounting firm Enron Corporation Chairman, CEO, CFO Established Special Purpose Entities (partnerships) to (1) hide debt; (2) create common equity; and (3) overstate earnings Mislead investors about company’s profitability and debt Lack of responsible corporate governance. Ineffective audit functions Filed for Chapter 11 bankruptcy protection, lost more than $60 billion in market capitalization, and more than 20 class action lawsuits were filed Global Crossing Top executives, principal officers Disclosing false and misleading financial statements, insider trading to inflate its market value Overstating revenues to meet the company’s performance goals Lack of diligent management and ineffective audit functions Filed for Chapter 11 bankruptcy protection. Loss of over $40 billion of market capitalization HBO & Company Four top executives, Co-President Earnings management from 1997 through March 1999 Exceed analysts’ quarterly earnings expectations Lack of vigilant board of directors and audit committee; lack of diligent management Share prices fell almost 50% in one day and class action lawsuits against the company KnowledgeWare Top management team Inflating the reported earnings by engaging in a phony software sale Meet analysts’ earnings expectations Lack of diligent management; irresponsible corporate governance The company was acquired at about one half of its previously agreed share price MicroStrategy, Inc. Three top executives Overstatement of revenues Inflate stock prices to increase demand for issuing new shares Lack of diligent management; lack of vigilant board of directors and audit committee Restatement of past financial results causing a 92.4% reduction in stock value Sunbeam Corporation Chief executive officer and four other former executives Earnings management by creating recorded revenue on contingent sales and using improper bill-and-hold transactions Improve company’s performance and restructuring strategies to meet analysts’ expectations Irresponsible corporate governance; ineffective audit functions Civil penalties and permanent bar of accused executives to become officers or directors of any public company WorldCom Chief financial officer, controller, and other executives Unlawfully and willfully falsified financial records by overstating earnings by more than $7 billion Inflate stock prices, cover up financial difficulties Greedy and arrogant executives, irresponsible corporate governance, ineffective audits Filed for Chapter 11 bankruptcy protection and indictment of top executives with criminal fraud 282 Z. Rezaee / Critical Perspectives on Accounting 16 (2005) 277–298 typically involve senior corporate officers. Thus, in many of these instances the SEC does not bring an enforcement action and they are not usually publicized. The Sarbanes-Oxley Act of 2002 contains several provisions designed to make top exec- utives of public companies more accountable regarding the quality, integrity, and reliability of financial reports. These provisions require that (1) CEOs and CFOs certify the accuracy and completeness of financial reports; (2) management be responsible for establishing and maintaining adequate and effective internal controls; (3) management does not take any ac- tions to fraudulently influence, coerce, manipulate, or mislead auditors in the performance of their audits of financial statements; (4) management should reconcile pro forma statements with financial statements; (5) management’s Discussion and Analysis (MD&A) sections should discuss and fully disclose critical accounting estimates and accounting policies; (6) top executives return any benefits they have received if it is proven that they misstated their company’s financial reports filed with the SEC; (7) companies prompt disclosure of insider stock trades; and (8) companies ban loans to their executives and directors. The proper implementation of these provisions of the Act is expected to influence the behavior of top executives of public companies and encourage them to be more conscientious regarding reporting their company’s financial performance and conditions. 3.2. Recipes The second letter in the word “CRIME” is “R,” which stands for “RECIPES.” Financial statement fraud can be committed in a variety of ways, ranging from most frequently occurring such as revenue frauds to least commonly occurring such as accounts payable frauds. Recipes of financial statement fraud can range from overstating revenues and assets to understating liabilities and expenses, which typically began with misstatement of interim financial statements and continue into annual financial statements. Earnings management is the most common method of engaging in financial statement fraud (i.e. distorting earnings to achieve earnings targets, analyst forecasts, and/or an earnings trend). Financial statement fraud can also vary in terms of direct falsification of transactions and events or intentional delay (early) recognition of transactions or events that eventually occur. An example of the former is intentional overstatement of sales by creating fictitious invoices whereas the latter would be involved in intentionally overstating sales using otherwise legitimate shipments after the end of the reporting period. Fictitious transaction frauds are often considered more aggressive methods of fraud schemes and occur more frequentl