Tag: Financial reporting

COSO Study Finds Accounting Frauds Getting Larger, Execs Named in Nearly 90% of Cases

If you could sum up the years of 1998 to 2007, how would you do it? Promising career crushed in a millisecond? A seemingly endless loop of awkward moments? Various forms of experimentation?

If you’re the Committee of Sponsoring Organization of the Treadway Commission (“COSO”) you’re more or lessway: Financial reporting fraud is getting bigger. Financial reporting fraud causes businesses to fail. CEOs and CFOs are usually the ones blamed.


If you’ve been paying attention at all, this probably doesn’t surprise you one iota but it is nice that COSO took it upon themselves to wrap it up in a nice little package entitled, Fraudulent Financial Reporting 1998-2007, An Analysis of U.S. Public Companies.

The report examined cases of alleged accounting fraud that were investigated by the SEC for the period. Some of the more interesting findings:

• Financial fraud affects companies of all sizes, with the median company having assets and revenues just under $100 million.

• The median fraud was $12.1 million. More than 30 of the fraud cases each involved misstatements/misappropriations of $500 million or more.

• The SEC named the CEO and/or CFO for involvement in 89 percent of the fraud cases. Within two years of the completion of the SEC investigation, about 20 percent of CEOs/CFOs had been indicted. Over 60 percent of those indicted were convicted.

• Revenue frauds accounted for over 60 percent of the cases.

• Twenty-six percent of the firms engaged in fraud changed auditors during the period examined compared to a 12 percent rate for no-fraud firms.

• Initial news in the press of an alleged fraud resulted in an average 16.7 percent abnormal stock price decline for the fraud company in the two days surrounding the announcement.

• Companies engaged in fraud often experienced bankruptcy, delisting from a stock exchange, or material asset sales at rates much higher than those experienced by no-fraud firms.

Lot of takeaways: bogus revenue is still popular, switching auditors is usually not a good sign (*ahem* Overstock.com), oh and if you cook the books, investors run away from you like a band of lepers.

Further, Compliance Week reports that the 347 cases reported is an increase from the 294 reported for the 1987-1997 period as well as tripling the average size of the fraud from $4.1 million to $12.05 million. The median assets and revenues of $100 million jumped from $16 million in the ’87/’97 range.

While this suggests that frauds are getting bigger, occurring at larger companies and as a result, destroying more wealth, the successful criminal prosecution of the people in charge of the companies doesn’t appear to be keeping up.

COSO Chair David Landsittel said, “All parties involved in the financial reporting process need to continue to focus on ways to prevent, deter, and detect fraudulent financial reporting,” although if the CEO or CFO (who certify the financial statements) are involved in the fraud, this statement doesn’t mean much. Sam Antar doesn’t think so either, telling us,

[W]e needed a study to find out that financial fraud leads to bankruptcy? Where have these guys been?Until we move away from the process oriented “check the box and fill in the blanks” routine in audits and start understanding criminal behavior, there isn’t much any auditor can do to deter fraud. Former Speaker of the House of Representatives Tip O’Neill once said, “All politics is local.” Similarly, we need to learn that “All fraud is personal.”

And since the SEC names a CEO or CFO in 90% of these cases, yet only 20% of those cases actually result in indictment within two years, does this indicate that the naming of said CEO/CFO is largely a photo op for the SEC/DOJ et al? Even if 60% of those executives are convicted it appears that finding fraud is (relatively) easy part; successfully blaming someone in the court of law is something else entirely.

One of the authors of the study, Mark S. Beasley of North Carolina State University noted that there is work still be done, “We need to determine if there are certain board-related processes that strengthen the board’s oversight of risks affecting financial reporting.” This seems to indicate that there is some significant high-level processes that are still not in place that could keep tabs on the Andy Fastows of the world but for now, we still seem to be going with the honor system.

COSO Press Release [COSO]
Fraudulent Financial Reporting 1998-2007, An Analysis of U.S. Public Companies [COSO]
COSO Fraud Study Catalogs Latest Decade of Incidents [Compliance Week]

For Some Large Companies, IFRS Is the Financial Reporting Equivalent of Y2K but What About the Little Guy?

It turns out that for many of the largest global companies, all this IFRS anxiety might be completely overblown. Companies with massive accounting departments and gurus leading the IFRS charge don’t seem to be all that concerned about accounting adjustments or costs, two areas that could cause headaches for smaller companies that are forced to adopt IFRS.

At the accounting conference at Pace University last week, some of the accounting gurus from the largest global companies reacted to the switch with “meh”:

They will be “underwhelmed,” says Aaron Anderson, director, IFRS policy and implementation at IBM…”When I look at the impact on IBM and compare it to whether investors will care, frankly, I don’t think they will.”
…
He pointed out that if the company moves all of its financial reporting to IFRS — and some of its foreign subsidiaries are already reporting under the international standards — the change wouldn’t be material in areas that investors “care about,” such as service contracts and product backlog, which are “numbers that are not reported in GAAP, anyway.”

Unfortunately, not every company has the good fortune to have a “Director of IFRS Policy and Implementation.” For some small businesses, the IFRS adoption could very well be headed up by the CFO of the company, assisted by the controller, with a couple of senior accountants pitching in. If things really get complicated (we’re talking about accounting rules, after all), then consultants could be called in to straighten help out but at what cost?

But even companies that do have someone spearheading this effort have a few concerns. Alcoa’s IFRS implementation director said the company won’t be on board until the inventory and derivatives issues have been worked out but everything after that will be NBD:

Klingler said that Alcoa won’t bless a conversion to IFRS until issues around inventory accounting are settled. Currently, Alcoa and other U.S. companies receive a tax benefit from using the last-in, first-out (LIFO) accounting method, which is banned by IFRS. Being forced to dump LIFO could cost those companies significant cash tax payments.

Alcoa executives are also concerned with understanding how hedging rules will change, said Klingler, since the company is a commodities supplier. However, “everything else will be small numbers” with respect to accounting adjustments, he said.

So a couple big ticket issues that will certainly be resolved and then Alcoa will be marching to IFRS no problem. For small companies, dumping LIFO or figuring out hedge accounting (again) could have a huge effect.

Back to the money issue. Many are worried that since the last big change in the industry — Sarbanes-Oxley — resulted in huge compliance costs, companies will spend another king’s ransom to adopt IFRS. But again, for the largest companies, they’ve more or less got the cost of conversion nailed down and aren’t that concerned:

Anderson conceded that switching to international standards will require “a lot of work,” but added that IBM, which has already started the process of preparing for a switch, knows “within a tight range” what it will cost — and in relative terms, “it won’t be very much.”

The concession of “a lot of work” is the cause for concern for small companies. Naturally, the more complex a business, the more work will be required to adopt IFRS but at least those companies have the manpower and the resources to weather the initial learning curve. Smaller companies may find themselves short staffed which could result in need of outside expertise (and thus spending a small fortune) to make adoption happen.

Unfazed by IFRS [CFO]

Regulators’ Exposure of Accounting Loophole Helped Banks Hide Risk

This story is republished from CFOZone, where you’ll find news, analysis and professional networking tools for finance executives.

Not exactly shocking news but one of the mysteries of the financial crisis is how it came to be that banks ended up with rtransferred to investors.

Sure, it’s well known that the assets banks removed from their balance sheets did not shift much risk to investors after all, thanks to liquidity guarantees they supplied to investors. But that even took former Citigroup vice chairman and Treasury secretary Robert Rubin by surprise, as Rubin said he didn’t know such guarantees existed until after the bank was forced to increase its capital reserves because it had to make good on them.

Now research that came out a year ago but was revised late last month helps clarify what went awry.


It turns out that a conflict between the Financial Accounting Standards Board and federal bank regulators was even more critical than I thought it was when I reported it in 2004. The conflict arose after FASB voted to require commercial banks to consolidate such vehicles after such financing arrangements caused energy trading firm Enron Corp. to fail.

I was aware that the regulators asked the FASB to delay the new accounting rule and that the board eventually provided an exemption for so-called “qualified” special purpose entities, which provided a loophole from consolidation so long as they vehicles weren’t actively managed.

But the full significance of that escaped me until I saw the research, which shows that securitization along the lines of Enron’s — guarantees that limited or even eliminated investor risk — exploded after bank regulators codified the exemption in their capital requirements. Indeed, the exemption essentially paved the way for banks to use more off-balance-sheet financing vehicles that masked their true risk.

How exactly? In late 2004, the Federal Reserve Board, Federal Deposit Insurance Corporation and the Office of Thrift Supervision decided that asset-backed commercial paper put into special purpose vehicles known as conduits would not have to be consolidated for purposes of calculating capital requirements. And the regulators decided that banks need only reserve against 10 percent of the amounts put into conduits even when they guaranteed that investors would be repaid if there were a run on the conduits. Previously, securitizations typically put investors on the hook for that risk.

The research, originally published in May 2009 but revised in late January and entitled “Securitization without Risk Transfer,” found that the amount of subprime assets securitized through such vehicles soared in the wake of the exemption, even though the liquidity guarantees extended to investors meant that little or no risk had been transferred to them.

“Regulation should either treat off-balance-sheet activities with recourse as on-balance sheet for capital requirement and accounting disclosure purposes, or, require that off-balance sheet activities do not have recourse to bank balance sheets,” the authors, Viral V. Acharya and Philipp Schnabl of New York University and Gustavo Suarez of the Federal Reserve, conclude. “The current treatment appears to be a recipe for disaster, from the standpoint of transparency as well as capital adequacy of the financial intermediation sector as a whole.”