Financial reporting fraud: prevention starts at the top.

• Author: Reidy, Mari
• Position: Fraud

Ten years after the collapse of Enron Inc. made financial reporting fraudfront-page news, the issue remains a serious concern for boards, investors and the public at large. Today's public corporations spend significant time and resources complying with complex regulatory structures that grew out of Enron and other accounting controversies.

But for board and audit committee members, as well as each and every financial executive, compliance alone is not enough. Even to-the-letter compliance with regulations is no guaranteethat "it can't happen here."

What is needed is a more comprehensive and proactive approach to reduce the risk of financial reporting fraud and mitigate its potential effects.

State of Financial Reporting Fraud

Although 2001 was a year in which financial reporting fraud generated significant and notable headlines, the issue is a perennial concern of every responsible executive. Recognizing this, three premier organizations--Financial Executives International (FEI), the National Association of Corporate Directors (NACD) and The Institute of Internal Auditors (IIA)--are collaborating with the Center for Audit Quality (CAQ), a public policy organization, in a longterm initiative to help organizations mitigate the risk of financial reporting fraud.

In conjunction with the announcement of this collaboration, CAQ released the report, Deterring and Detecting Financial Reporting Fraud, A Platform for Action.

Many other organizations also have researched the issue at considerable length. Recent examples include separate studies by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and the Association of Certified Fraud Examiners (ACFE).

These various studies have generated some new insights and reinforced some long-held understandings about the problem. For example, ACFE's 2010 Report to the Nations on Occupational Fraud and Abuse found that although asset misappropriation schemes are the most common form of occupational fraud, financial reporting fraud is a dramatically more costly issue.

Although 90 percent of the cases reviewed in the ACFE survey involved asset misappropriation, the median loss in these cases was $135,000. In contrast, financial statement frauds accounted for fewer than 5 percent of the cases, but were by far the most costly--causing a median loss of more than $4 million per case.

The 2010 COSO report, Fraudulent Financial Reporting: 1998-2007, An Analysis of U.S Public Companies, zeroes in on this particular type of fraud, reviewing 347 instances of alleged fraudulent financial reporting by registrants of the U.S. Securities and Exchange Commission.

Among the study's findings: "The two most common techniques ... involved improper revenue recognition and asset overstatements. The majority of frauds (61 percent) involved revenue recognition, while 51 percent involved overstated assets primarily by overvaluing existing assets or capitalizing expenses."

Legislative and Regulatory Responses

Have the legislative and regulatory responses in the years since Enron had a significant effect on the problem? The 2010 COSO report was unable to reach a conclusion about the effectiveness of the Sarbanes-Oxley Act of 2002, noting that a relatively small number of frauds examined in the study involved time periods subsequent to the issuance of the act.

On the other hand, when CAQ posed this question in a series of round-table discussions, it received a positive...