The Changing Face of the US SEC’s Enforcement

Investigations (AAERs) into Financial Statement Fraud in the

Post-Enron Environment

By

Richard Lane#James Cook University

Brendan T. O’Connell†James Cook University

# School of Business, James Cook University, Townsville, Queensland, Australia 4811

† Professor, School of Business, James Cook University, Townsville, Queensland, Australia 4811

Corresponding Author: Brendan O’Connelle-mail: brendan.oconnell@jcu.edu.au Phone: ++61 7 4781 5081 FAX: ++61 7 4781 4019

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The Changing Face of the US SEC’s Enforcement Investigations (AAERs) into Financial Statement Fraud in the

Post-Enron Environment

Abstract

This study examines the U.S. SEC’s investigations into financial statement fraud

through an analysis of Accounting and Auditing Enforcement Releases (AAERs) from

2002 to 2005. Our study seeks to correct perceived deficiencies (Briloff, 2001;

O’Connell, 2001) in the sampling process employed in the COSO Report (1999) which

examined AAERs from 1987 to 1997. This paper is also motivated by the need to

examine the changing environment, post-Enron, toward regulation of accounting fraud.

Using an institutional theory framework it was hypothesized that the post-Enron

environment may have brought about changes in the activities of the SEC in an effort for

this agency to legitimize itself before major stakeholders. Our study finds evidence of

changes in SEC enforcement activities since the COSO Report (1999). Specifically, we

find that enforcement activities have increased substantially post-Enron and the

companies subject to AAERs were, on average, much larger, more profitable and the

frauds more substantial than those exhibited in the COSO Report (1999). These findings

suggest that the SEC has become more aggressive at pursuing larger companies for

financial statement fraud in the post-Enron environment.

Key words: institutional theory; financial statement fraud; SEC; Accounting and

Auditing Enforcement Releases.

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The Changing Face of the US SEC’s Enforcement Investigations (AAERs) into Financial Statement Fraud in the

Post-Enron Environment

“In law, what plea so tainted and corrupt,But, being seasoned with a gracious voice,Obscures the show of evil?”

William Shakespeare in The Merchant of Venice, act 3, sc. 2, l. 75-7.

In Shakespeare’s The Merchant of Venice a major theme is that of deception and

disguise. People are deceived by ornament. The outward appearance of people, ideas,

laws, and objects can sometimes mask reality (Perell, 2006).

The forthcoming analysis of the U.S. Securities and Exchange Commission’s

(SEC’s) Accounting and Auditing Enforcement Releases (AAER’s) seeks to provide

valuable insights into the characteristics and realities of financial statement fraud within

US companies during the period 2002 to 2005. Employing a cross-case analysis of

AAERs, our study documents how senior management of these companies deliberately

sought to hide the realities of their company’s performance from stakeholders often

across many years. In this way, we aim to expose the “ornament” that masks the reality of

these companies.

In addition to our intention to enhance understanding of a sample of US financial

statement frauds, the present investigators also seeks to compare our findings with those

reported by the Committee of Sponsoring Organizations of the Treadway Commission

1987-1997 (COSO Report, 1999). Specifically, we aim to identify common

characteristics of financial statement fraud pre and post issuance of that report and

whether the focus of SEC prosecutions has changed over that period. The reason that we

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have selected this comparison is to study whether “high profile” accounting scandals such

as Enron and WorldCom have resulted in changes to the foci of investigations conducted

by the SEC and the targets of those investigations.

The theoretical basis of our study is drawn from institutional theory. Institutional

theory adopts an open system perspective where organizations are strongly influenced by

their environments (DiMaggio & Powell 1983; Bealing et al. 1996). We hypothesize

that, post-2001, the SEC responded to the voluminous criticism of companies legislation

and enforcement emanating from the major accounting scandals by significantly

increasing the number and scale of its enforcement activities to ensure maintenance of its

societal legitimacy.

LITERATURE REVIEW

COSO Report (1999)

In 1999, the Committee of Sponsoring Organizations of the Treadway

Commission (COSO) released the study, Fraudulent Financial Reporting: 1987-1997, An

Analysis of US Public Companies (COSO Report, 1999). The Report has since been

widely circulated and cited (see, for example, Wells, 2001; Beasley, Carcello ,

Hermanson, & Lapides, 2000). The COSO Report (1999) boasted that, “For the first time,

we have a clear understanding of the who, why, where and how of financial reporting

fraud” (p.1.). These researchers analyzed AAERs issued by the SEC over an 11 year

period between January 1987 and December 1997. The subject of their analyses were

instances of alleged violations of Rule 10(b)-5 of the 1934 Securities Exchange Act or

Section 17(a) of the 1933 Securities Act, they being the main anti-fraud provisions that

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relate to financial statement reporting. A random sample of 220 cases of financial

statement fraud were subjected to analysis, however, the researchers found that only in 99

cases were they able to obtain the “last clean financial statements” (p.15).

Major findings of the COSO Report were that the companies involved in financial

statement fraud tended to be relatively small; some companies committing the fraud were

experiencing net losses or were close to break-even prior to the fraud; top senior

executives were frequently involved; cumulative amounts of fraud were relatively large

relative to company size and were not isolated to a single period; and, typical fraud

techniques involved overstatement of revenues (COSO Report, 1999: 5-6).

Criticisms of AAERS and the COSO Report (1999)

There have been several studies utilising AAERs which have alluded to their

limitations (see, for example, Feroz et al., 1991; Bonner et al., 1998) and critiques of the

COSO Report (1999) itself (see, for example, Briloff, 2001; O’Connell, 2001). In terms

of the limitations of AAERs themselves, Feroz et al. (1991) report that SEC enforcement

actions differ in their nature and severity. Bonner et al. (1998) recognized this problem

and attempted to control for differences in severity by assigning each action a value for

severity from the external auditor’s perspective. Bonner et al. (1998) also emphasized the

strong possibility of selection bias emanating from reliance on AAERs. They specified

that these enforcement actions might reflect specific SEC agendas prevailing at the time

of the sample selection (p. 505). If this is the case, sole reliance on enforcement actions

might not produce a sample of frauds that is truly representative of the entire population

of financial statement frauds.

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The SEC admits that its enforcement program is designed to “concentrate on

particular problems areas and to anticipate emerging problems” (SEC, 1989, p. 1). As an

example of this SEC agenda bias, Feroz et al. (1991) reported that 70% of all AAERs

issued between 1982 and 1989 related to alleged overstatement of accounts receivables

and inventories by firms. Furthermore, Feroz et al. (1991, p. 111-2) highlighted that

interviews with current and former SEC officials show that the SEC has more targets for

formal investigations than it can practically pursue and that they need to limit their

investigations to instances where material violations are alleged to have occurred. They

noted that formal investigations are both costly and highly visible and this means that the

SEC is forced to rank candidates for formal investigation “according to the probability of

success and potential message value” (Feroz et al., 1991, p. 112).

Turning to evaluation of the COSO Report (1999) itself, perhaps the most high

profile of these critiques was Briloff (2001). Key aspects of his criticism were that the

selection process produced a group of companies that were not representative of the high

profile cases that, in his view, were “contaminating the accounting and financial reporting

environment” (p.126). Briloff was especially critical of the obvious lack of high profile

cases in the sample given the small size of companies reflected in the demographic data

of the study. Briloff (2001) then produced his own study to support this claim. He

emphasized that the company with the highest total revenue almost equaled the total

revenues of the remaining 98 companies. He concluded that the sampling approach

created a “distorted image of the corporate enterprises in our financial reporting

environment.” (p.126).

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O’Connell (2001) supported Briloff’s claim stating that “researchers who have

used AAERs also recognize the limitations of relying on AAERs to evaluate financial

statement fraud” (p.168). He highlighted that they differ in their nature and severity and

that they are uneven in their level of disclosure. Further, O’Connell (2001) criticized the

absence of details of individual cases in its sample. He stated that “this lack of financial

data on sample firms is clearly frustrating and a major limitation of the COSO Report”

(p.171).

O’Connell (2001) also evaluated the sampling approach of the COSO Report

(1999). He noted that one of the major conclusions of the COSO Report (1999) is that

“companies committing financial statement fraud were relatively small” (p 2). He argued

that this finding is only valid if one assumes AAERs are truly representative of all

financial statement fraud and if one assumes that the omitted firms are similar in

character to those 99 firms portrayed in the COSO Report (1999). O’Connell (2001)

observed that if one assumes both of these conditions are met then the population will be

skewed towards smaller firms. Moreover, when a population is skewed one way and a

random sample is taken from that population, then the resultant sample is likely to reflect

that particular distribution shape (in this case, a plethora of small firms and not too many

large ones).

O’Connell (2001) concluded that such a sampling outcome is of great concern in

this case as it is the high profile cases of financial statement fraud that make the front

pages of the Wall Street Journal and that if one is concerned about restoring public faith

in the accounting profession, then one must study and enhance understanding of what

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drives these high profile cases. To enhance the usefulness of the COSO study, he

advocated a sampling approach that includes large, high-profile cases.

The SEC and Institutional Theory

Any study that utilizes AAERs as a primary data source cannot draw conclusions

from them without first considering the institutional environment in which these

enforcement releases are issued. Accordingly, we will draw on institutional theory to

inform our analysis.

Institutional theory, according to Scott (1987) and DiMaggio and Powell (1983),

proposes that many aspects of formal organizational structures, policies and procedures

result from prevailing societal attitudes and the views of important constituents (p.53.).

Organisations obey these rules and requirements, not just on efficiency grounds, but also

to enhance their legitimacy, resources, and survival capacities (Kondra & Hinings 1998).

Institutional pressures operate in conjunction with other forces such as competition to

effect ecological dynamics. Organisational behaviour is inextricably ingrained in a

vibrant system of interrelated economic, institutional, and ecological influences

(DiMaggio & Powell 1983).

Of relevance to the present study, Bealing et al. (1996) utilized institutional theory

to examine the historical development of the SEC and, in particular, the form, content and

rhetoric of its early regulatory actions as a case example of an organisation attempting to

justify its existence and role in the financial markets. They found “that in order for the

SEC as an organization to become legitimated…as part of the regulatory arena, it had to

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take part in building up…a framework of social control applied to the accounting

profession as well as reporting entities” (p.335).

Bealing et al. (1996) found that the SEC’s legitimacy was considerably enhanced

when it began issuing enforcement releases. They concluded that by clearly stating the

appropriate audit and accounting procedures that should have been in place but were not,

the SEC established itself as an exemplar “of professional service within public

accounting” and that it was able to protect the investing public through ensuring “full and

fair disclosure to investors of all material facts” (p.335).

Using institutional theory, it would seem that following the considerable fallout

from the Enron and WorldCom accounting scandals of the early part of this decade, the

SEC would sharpen its focus in pursuing financial statement and accounting fraud.

Certainly the pronouncements of politicians (see, for example, Bush, 2002a;b;c) and the

passage of the Sarbanes-Oxley Act of 2002 reflect the prevailing environment for major

reform of corporate regulation and a tougher stand generally on unscrupulous behavior by

corporate executives. In such an environment, the SEC would not be immune from

pressure to increase the rate and intensity of its surveillance of company reporting. This

pressure is likely to manifest itself in the AAERs issued post-2001.

Research Hypotheses

As noted earlier, a major objective of this study is to identify what key

characteristics, if any, of the AAERs have changed post the period covered by the COSO

Report (1999). We hypothesize that the changed institutional environment following the

accounting scandals may have impacted on the level of AAERs issuance, the size of

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companies subject to AAERS and the nature of the allegations. Specifically, we test the

following six hypotheses:

H1: There has been an increase in the issuance of AAERs by the SEC in the period after 2001, that is, post the US accounting scandals.

This first hypothesis is based on the hostile environment faced by the SEC and

other regulators in the wake of Enron, WorldCom and other accounting scandals (see, for

example, Rockness & Rockness, 2005; Bush, 2002a,b&c). Using institutional theory, one

would expect to see the SEC react to this changed environment by actively seeking out

new cases of possible fraud or risk losing its institutional legitimacy (Kondra & Hinings

1998). Notwithstanding any possible legitimacy concerns, the post-Enron fallout may act

as a signal to the SEC that its surveillance activities needed to be boosted.

H2: There has been an increase in the size of companies subject to issuance of AAERs by the SEC in the period after 2001, that is, post the US accounting scandals.

This second hypothesis reflects the “high profile” nature of the major accounting

scandals. The COSO Report (1999) concluded that the vast majority of frauds in its

sample involved small companies. Consistent with institutional theory, one would expect

to see that following the accounting scandals of 2001, the SEC would aggressively pursue

“high profile” cases and trumpet any prosecutions as vindication of its pivotal role in

ensuring reliable financial disclosures to investors. As noted by De Fond and Smith

(1992) “the SEC Enforcement Division chooses cases that enhance its stature as an

effective law enforcement agency” (p.144). It follows that larger companies are likely to

have been subject to AAERS since 2001. It may also be plausible that the Enron fallout

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alerted the SEC to potentially greater instances of fraud in large companies. It follows

that the SEC’s enforcement activities of larger entities may have increased for this reason

post-Enron.

Examples of this increasingly aggressive approach toward “high profile” cases are

found in SEC press releases from 2002 onwards. For example, in a 2002 press release

relating to SEC investigations concerning the well publicised case of Tyco International

(SEC, 2002), the SEC Director of Enforcement is quoted as follows:

This enforcement action is the latest chapter in the Commission's ongoing investigation, together with the Manhattan District Attorney, of corruption and self-dealing at the highest levels of Tyco management … The Commission today, together with the criminal authorities, serves notice that misconduct by outside directors, as well as by company management, will not be countenanced (SEC Press Release Number 2002-177).

Similarly, an SEC Press Release in 2003 relating to another well publicized fraud,

Vivendi Universal, included the following quote from the Deputy Director of the

Commission's Division of Enforcement:

This case shows the Commission's ongoing commitment to enforcing the disclosure obligations of issuers and it shows our successful use of a new enforcement tool provided by the Sarbanes-Oxley Act (SEC Press Release Number 2003-184).

The following four hypotheses are directly derived from the findings of the COSO

Report (1999). Specifically, that report found that many companies committing the fraud

were experiencing net losses or were in close to break-even situations; most frauds were

not isolated to a single fiscal period and large relative to the company size; the frauds

tended to involve improper revenue recognition or overstatement of assets; and, very

senior executives were frequently involved (p.5-6).

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H3: Companies subject to issuance of AAERs by the SEC are likely to exhibit poor financial condition in the period leading up to the period of alleged accounting fraud.

H4: The alleged accounting frauds pertaining to companies subject to issuance of AAERs by the SEC are likely to have occurred over multiple periods and to involve large amounts relative to the company size.

H5: The alleged accounting frauds pertaining to companies subject to issuance of AAERs by the SEC are likely to involve improper revenue recognition or overstatement of assets.

H6: The alleged accounting frauds pertaining to companies subject to issuance of AAERs by the SEC are likely to have been orchestrated by the most senior executives of companies, that is, the CEO and the CFO.

RESEARCH METHODOLOGY

The present investigators commenced the study by identifying those AAERs that

involved an alleged breach of Rule 10(b) – 5 of the Securities Exchange Act 1934 or

Section 17(a) of the Securities Act of 1933 or other Federal anti-fraud statutes. These are

the sections that represent the primary antifraud provisions relating to financial reporting.

Excluded from the analysis were restatements of financial reports due to errors or any

activities that did not result in a violation of federal antifraud statutes. This approach was

consistent with that of the COSO Report (1999).

The present investigators reviewed 870 AAERs for the four-year period between

January 2002 and December 2005. The search identified 350 AAERs that related to

fraudulent financial reporting between 2002 and 2005 (a period deliberately chosen to

reflect the post-Enron fallout). However, there were multiple AAERs for some cases

amongst the 350 identified. Where there were multiple AAERs relating to one company,

these were counted as one1. This reduced the number of companies to 330. A random

1 In some cases a separate AAER was issued for the company and for each individual executive involved in the accounting fraud.

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sample of 55 was taken from this group of companies which compares to a final sample

of 99 cases for the COSO Report. Appendix One lists each of the 55 cases used in our

sample together with key characteristics of each case2. Table 1 below shows a

comparison of the sampling approach used in the present study to that of the COSO

Report (1999).

INSERT TABLE 1 ABOUT HERE

In addition to a random sample of all AAERs for the study period, the present

study has adopted the recommendation of O’Connell (2001) in using a sampling

approach which deliberately adds five large “high profile” cases of financial statement

fraud. The five cases examined are Waste Management, Qwest Communication, Tyco

International, HealthSouth Corporation and Adelphia Communications.

This approach avoids the sampling problem of the COSO Report (1999) which

led Briloff (2001) to conclude that it was not representative of the “really stinking stuff

which is contaminating the accounting and financial reporting environment” (p.126). As a

consequence of this sampling approach, high profile companies make up 8.3% of the total

sample. None of these cases were duplicated in the random sample. A detailed analysis of

the “high profile cases” is found later in this paper.

It should be noted that we deliberately did not include Enron and WorldCom in

the sample as we felt that these scandals had already been subject to a considerable

amount of prior research and analysis (see, for example, Benston & Hartgraves, 2002;

2 Briloff (2001) was also critical of the absence from the COSO Report (1999) of such a list.

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O’Connell, 2004). Accordingly, we think that the facts and circumstances of these two

cases are quite well understood.

There are six key characteristics of AAERs that were specifically examined in this

study. All of these six were also studied in the COSO Report (1999): the size of the

company committing the alleged financial statement fraud; the financial condition of the

company in the period prior to the alleged fraud; which senior executives were involved

in the alleged fraud; the cumulative amount of alleged fraud compared to the size of the

company; whether the alleged fraud covered more than one fiscal period; and, the typical

financial statement fraud techniques involved.

In addition to this analysis of AAERs, we conducted a qualitative content analysis

of the AAERs to ascertain common key motives behind the financial statement frauds.

This latter analysis we believe adds considerably to the richness of our understanding of

the factors behind these phenomena and was not undertaken in the COSO Report (1999).

RESULTS AND DISCUSSION

SEC Issuance of AAERS

Our findings support hypothesis one which proposes that there has been an

increase in the issuance of AAERs by the SEC in the period after 2001, that is, post the

US accounting scandals. The COSO Report (1999) utilised all AAERS issued between

January 1987 and December 1997. The authors of that report stated the following:

We read over 800 AAERs, beginning with AAER#123 and ending with AAER#1004. From this process, we identified nearly 300 companies involved in alleged instances of fraudulent financial reporting (p.12).

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The final sample of the COSO Report was then randomly selected from that group

of 300. If we compare these figures to those of the present investigation, there has been a

marked increase in issuance of AAERs in recent years. Our analysis reveals that over the

four year period between 2002 and 2005, a total of 871 AAERs were issued. The

breakdown is as follows: 212 in 2002, 239 in 2003, 220 in 2004 and 200 in 2005. When

we identified which of these AAERs alleged fraud violations related to Rule 10(b)-5 of

the 1934 Securities Exchange Act or Section 17(a) of the 1933 Securities Act, a direct

comparison with the COSO Report approach, we found that 351 had been issued during

the study period. The split is as follows: 95 in 2002, 121 in 2003, 68 in 2004 and 67 in

20053. It follows that the SEC issued AAERs at a far higher rate in the period 2002 to

2005 when compared to 1987-1997. In just a four-year period almost as many AAERs

were issued as for the entire 11-year period studied by the COSO Report (1999).

Furthermore, those AAERs that specifically related to financial statement fraud appeared

to have risen substantially since the 1990s. It should also be noted that many of these

were issued in the period immediately after the scandals i.e. 2002 and 2003.

These findings could be explained by two possibilities. First, the SEC seeking to

legitimize itself to stakeholders through a greater focus on possible fraudulent financial

reporting. While the SEC did receive an injection of funding from 2002 onwards to

combat corporate fraud (see, Bush, 2002b) the prevailing climate in the US following the

accounting scandals of 2000-2001 meant that the SEC needed to be seen to be vigilant in

this area. They may have acted as predicted by institutional theory. Second, the SEC

stepped up its enforcement activities post-Enron following a realization that financial

statement fraud was more prevalent than previously envisaged.

3 It should be noted that the COSO Report (1999) did not report a year-by-year dissection of AAERs.

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Size of Companies Committing Financial Fraud

The COSO Report (1999) stated that the sample companies are relatively small in

size. The company size (total assets and revenue) comparisons between the COSO Report

(1999) and the present study are shown in Table 2.

INSERT TABLE 2 ABOUT HERE

The COSO Report (1999) stated that the “companies committing financial

statement fraud were relatively small” and that “most of the sample companies ranged

well below $100 million in total assets” (p.5). As depicted in Table 2, the COSO Report

(1999) found mean total assets of companies subject to AAERs were $533 million

(median of $15.7 million). This compares with $3.3 billion (median of $187 million).

These figures represent a 522% increase in the mean total assets and a 1,092% rise in the

median. Turning to total revenues, the COSO Report (1999) portrayed a mean of $233

million (median of $13 million). This compares with the present study’s equivalents of

$3.1 billion and $62.6 million respectively. These figures depict a 1,232% increase in the

mean total revenue and a 380% rise in the median.

It should be noted that we did not conduct statistical comparisons of the two

groups (present study sample versus COSO Report sample) relating to company size

because the authors of the COSO Report (1999) did not identify which specific AAERs

were included in their analysis. Their report provided only aggregated findings and hence

a valid statistical comparison such as a chi-square test is impossible4. Standard deviations

are also not reported because our sample (together with that of the COSO Report, 1999) 4 It should be noted that both Briloff and O’Connell personally contacted the authors of the COSO Report (1999) in 2001 in an effort to obtain details of the AAERs included in their sample but were informed that due to confidentiality issues with regard to the Treadway Commission they were not prepared to release this information to us.

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is heavily positively skewed. Reliance on a standard deviation would be misleading in

such a skewed distribution and consequently, median and quartile results are provided

instead to provide a more meaningful picture of the empirical data (Tabachnick & Fidell,

2001).

Clearly, the companies within the COSO Report (1999) sample are considerably

smaller, on average, than those in the present study regardless of whether the samples are

compared on the basis of their means, medians or quartiles. Hence, hypothesis two which

states that there has been an increase in the size of companies subject to issuance of

AAERs by the SEC in the period after 2001 is supported by our results notwithstanding

the inability to conduct a statistical comparison as noted in the previous paragraph.

There are several possible conclusions that can be drawn from these findings.

First, that the COSO Report (1999) sampling approach was skewed towards smaller

companies. However, this seems unlikely as the COSO Report (1999) claims to have

randomly selected its sample so this would suggest that it was representative of the

population of the time. Second, that the SEC deliberately selected larger, more “high

profile” companies post-2001 for prosecution consistent with an institutional theory

argument or because they came to the realization that financial statement fraud was more

prevalent in large companies than previously thought. This may be quite plausible in light

of the evidence presented here and the pronouncements of the SEC mentioned earlier.

Third, that the frauds committed post-1998 were generally much larger than pre 1998.

This would seem unlikely. Fourth, potential frauds were less likely to be detected and/or

prevented prior to 2001 and were less likely to be prosecuted by the SEC especially

where larger companies were concerned. Again, this would seem improbable.

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Profitability of Companies Committing Financial Fraud

Consistent with the COSO Report (1999), we examined the net income for the

year prior to commencement of the fraud. Our findings are displayed in Table 3 and show

a far higher net income figure for our sample (mean of $48.3 million, median of $1.8

million) when compared to the COSO Report (mean of $8.6 million, median of

$175,000). This represents a 463% increase in the mean and a 929% increase in the

median.

INSERT TABLE 3 ABOUT HERE

These findings contrast somewhat with the COSO Report (1999) which concluded

that “pressures of financial strain or distress may have provided incentives for fraudulent

activities for some fraud companies” (p.5). Companies in the present investigation were

generally profitable in the lead up period to the fraud so the incentive to commit fraud

appears to have come from other factors. In fact, only 14 out of 55 of our sample (25.5%)

reported a loss in the period immediately prior to the alleged fraud. These findings do not

support hypothesis three which stated that companies subject to issuance of AAERs by

the SEC are likely to exhibit poor financial condition in the period leading up to the

period of alleged accounting fraud.

Our qualitative analysis of AAERs provided valuable insights into why executives

in the sample resorted to financial statement fraud despite many of the sample being quite

profitable entities. It is apparent that pressure to achieve Wall Street analysts’ profit

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forecasts was a recurring theme at the heart of many of these frauds and was commonly

mentioned in the AAERs:

RSA stated that it had achieved analysts’ earnings expectations for the first quarter of 2001 … without the accounting change [a new, aggressive method of recognizing sales for shipments to distributors] RSA would have failed to meet analysts’ earnings expectations by approximately $0.02 per share or 12.5%, and its operating income would have been 17.3% lower (AAER No. 1817, RSA Security, July 23, 2003).

In the Spring of 1999, Miller [former CEO] devised and implemented a scheme to fraudulently overstate the company’s net income to meet analysts’ expectations. Pursuant to the plan, the company fraudulently reclassified rent and salary expenses that Master Graphics had already paid to its division presidents in the first quarter to assets on the company’s balance sheet thus reducing expenses and increasing income (AAER No. 2035, Master Graphics, June 14, 2004).

Stockholders’ Equity (Deficit) of Companies Committing Financial Fraud

Our analysis of stockholders’ equity in the period preceding the financial fraud

reveals a similar picture to that of the profitability analysis. As shown in Table 4, the

COSO Report (1999) reported a mean Stockholders’ Equity of $86.1 million (median of

$5 million). Our investigation shows a mean stockholders’ equity of $735.1 million

(median of $58.2 million). These findings reflect a 753% higher mean and a 1,062%

larger median for the sample in the present study. Again, hypothesis three is not

supported by these findings.

INSERT TABLE 4 ABOUT HERE

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Executives Named in the AAERs

Table 5 depicts that there is a marked difference in the results obtained in the

present study and those found in the COSO Report (1999). The COSO Report (1999)

found that the Chief Executive Officer (141 companies or 72% of the sample) was the

highest ranking executive involved in most fraud cases5. In the present investigation, the

senior executive most frequently named was the Chief Financial Officer (33 companies

representing 60% of the sample). There also seems to be a greater spread of individuals

cited in this study. The Controller (13% of sample), Chief Operating Officer (16%) and

other Vice President Positions (20%) were commonly mentioned in the AAERs.

However, it should be noted that the companies in our sample are, on average, much

larger than that of the COSO Report (1999). Hence, this greater spread of accused may

simply reflect the greater size and complexity of the companies in our study. Our findings

generally support hypothesis six which states that the frauds are likely to have been

orchestrated by the most senior executives of companies, that is, the CEO and the CFO.

As Table 5 shows this is clearly the situation in most cases.

INSERT TABLE 5 ABOUT HERE

Our qualitative analysis of AAERs offers important insights into the direct

involvement of unscrupulous senior executives in many of the frauds:

Signal Tech’s former management created a corporate atmosphere which encouraged managers to engage in improper accounting in an effort to improve Signal Tech’s bottom line. Signal Tech’s former chairman and other senior officers expressed scorn for accounting principles. … As a

5 It should be noted that in determining Table 5, the highest managerial title for an individual was used.

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result of the pressure for profits at all costs and disdain for accounting principles by former senior officers … Keltec’s controller knowingly allowed improper accounting practices … Moreover, Signal Tech’s senior officers personally directed specific improper accounting practices and dictated misleading entries to be made on Keltec’s books to overstate revenue and understate costs (AAER No. 1534, Signal Technology, March 27, 2002).

During the first and second quarters of 2000, the CFO placed substantial pressure on the Controller to continue to meet analysts’ earnings expectations in reported results. As a result of that pressure, the Controller intentionally failed to record certain operating expenses which were material to both quarters (AAER No. 1691, Mercator Software, December 16, 2002).

Cumulative Dollar Amount of Fraud for a Company

As shown in the Table 6 the average fraud amount in our sample involved $137

million of cumulative misstatement or misappropriation (median of $10.8 million)6. This

is much higher than those found in the COSO Report (1999) where a mean and median of

$25 million and $4.1 million respectively were reported. This comparison indicates a

448% increase in the mean size of the fraud and a 163% rise in the median. Moreover, the

cumulative amounts of the fraud were quite high relative to the size of the company. The

median fraud of $4.1 million for the COSO Report (1999) sample represented 25% of

median total assets ($15.7 million). In our sample, the median fraud of $10.8 million

represented 6% of median total assets ($186.9 million). In both samples, the median fraud

amount considerably exceeded the median net income. It follows that hypothesis four is

supported as the frauds do, on average, involve large amounts relative to company size.

6 It should be noted that on a few occasions the AAERs did not fully disclose the quantum of dollars relating to the fraud. Accordingly, we conducted additional research through the SEC’s Litigation Releases et al, [found at http://www.sec.gov/litigation/litreleases.shtml] to ascertain the precise fraud amount.

21

INSERT TABLE 6 ABOUT HERE

Qualitative analysis of the AAERs shows a recurring theme that executives

perceived that their manipulations of reported earnings would have a significant impact

on the share price and their associated bonuses:

The compliant alleges that Gless [former CFO] and other Peregrine senior officers engaged in deceptive practices to artificially inflate Peregrine’s revenue and stock price, and that Gless then took fraudulent action to conceal the scheme (AAER No. 1759, Peregrine Systems, April 16, 2003).

In 2001 and 2002 Huntington reported inflated earnings in its financial statements, enabling Huntington to meet or exceed Wall Street analyst earnings per share expectations and internal EPS targets that determined bonuses for senior management (AAER No. 2251, Huntington Bancshares, June 2, 2005).

Length of Fraud Period

The COSO Report (1999) found that the average fraud was for two years with a

median of 21 months (p.30). Table 7 indicates that 36% of frauds in the current study

related to one year or less with 36% between one and two years, and 18% lasting for

three years. In all, 64% of all frauds in our sample were for greater than one year. These

results are consistent with hypothesis four in indicating that many frauds occur across

multiple periods.

INSERT TABLE 7 ABOUT HERE

Common Financial Fraud Techniques

As can be seen in Table 8, by far the most common technique used to fraudulently

misstate financial statement information in our sample involved deliberate overstatement

22

of revenue. In fact, 96% of alleged fraud involved this method. In the COSO Report

(1999), 50% of the sample employed this method suggesting either the SEC has

deliberately increased its surveillance activities in this area or that this type of fraud has

become far more prevalent since the 1990s. The second most common technique to

fraudulently misstate financial statement information was the overstatement of assets

(53%). However, the use overstatement of assets and understatement of

expenses/liabilities have remained relatively consistent across the two periods.

Misappropriation of assets has declined somewhat across the two periods (down from

40% in the COSO Report to 11% in the present study). The above findings support

hypothesis five in that the sample frauds commonly involved improper revenue

recognition or overstatement of assets.

INSERT TABLE 8 ABOUT HERE

Our qualitative analysis of AAERs provided detailed descriptions of the types of

techniques employed by executives to misrepresent the company’s financial performance.

The deliberate overstatement of revenue stands out as the preferred option for accounting

fraud:

[Senior executives] falsely reported millions of dollars of non-existent sales, including sales to a fictitious customer, and used other fraudulent techniques to inflate Anicom’s revenues” (AAER No. 1554, Anicom, May 6, 2002).

During the period from January 1996 through June 1998, Signal Tech’s Keltec division prematurely recognized revenue, failed to record contract losses and failed to write down excess inventory. Signal Tech’s former Chairman and CEO, former CFO, and other former senior corporate officers, knew of and in multiple instances personally directed improper

23

accounting practices. On several occasions the former chairman and other senior officers even dictated specific misleading entries to be made on Keltec’s books (AAER No. 1534, Signal Technology, December 16, 2002).

ANALYSIS OF FIVE HIGH PROFILE COMPANIES

Two of the main criticisms of the COSO Report (1999) by Briloff (2001) and

O’Connell (2001) are a paucity of “high profile” cases in that sample and the lack of

disclosure of the specific AAERs scrutinized by those investigators. In contrast, the

present study provides details of all AAERs examined (see Appendix One) and uses a

sampling approach that specifically includes an analysis of five high profile cases during

the study period. The five frauds examined are Waste Management, Qwest

Communication, Tyco International, HealthSouth Corporation and Adelphia

Communications.

Table 9 displays a summary of the key characteristics of the five major frauds.

Appendix Two provides an overview of each of these five frauds.

INSERT TABLE 9 ABOUT HERE

Table 9 shows that these five companies were large varying from a minimum of

$1.6 billion in total assets through to a maximum of $8.1 billion (mean of $4.6 billion).

The accumulated amount of the frauds was also sizeable varying from a minimum of

$567 million through to a maximum of $3.5 billion (mean of $1.9 billion). It should also

be noted that these fraud amounts were significant when compared to each company’s

revenue or profit situation. For example, in 60% of the cases the accumulated fraud

amount exceeded the company’s total revenue from the previous year’s financial result.

In all cases the frauds covered several reporting periods with a minimum of 4 years and a

24

maximum of 7.5 years (mean of 5.5 years). The CEO was implicated in the fraud in all

cases with the CFO prosecuted in 80% of them. In 40% of the cases, the company was

quite profitable in the year preceding the fraud (as measured by net income). In another

40%, the company reported a large loss the previous year and in the remaining case the

company reported a small loss. Artificial inflation of reported earnings was at the centre

of the prosecution in all but one of the cases.

Our qualitative analyses of the AAERs show that an inappropriate “tone at the

top” was a key issue in most of these cases:

The business unit executives made it clear that subordinates had to meet or exceed these aggressive earnings targets at all costs (AAER No 2209, Qwest Communications International, issued March 15, 2005).

This is a looting case …it involves egregious, self-serving and clandestine misconduct by the three most senior executives at Tyco (AAER No 1839, Tyco International, issued August 13, 2003).

The ubiquitous issue of pressure to appease analysts’ forecasts also was a

common theme:

The complaint was that these eight officers artificially accelerated Qwest’s recognition of revenue in two equipment sale transactions for its Global Business Markets Unit It is alleged that that when the Qwest financial management indicated the company would miss its quarterly targets, the Global Business Markets officers would bridge the gap by fraudulently mischaracterizing these transactions (AAER No 1726, Qwest Communications, issued February 25, 2003).

In summary, the findings from these five high-profile cases largely support those

of the 55 randomly selected cases. The extent and nature of the frauds was significant and

the companies involved were substantial in size.

CONCLUSION

25

This study set out to examine the U.S. SEC’s investigations into financial

statement fraud through an analysis of AAERs from 2002 to 2005. Findings were

compared to the COSO Report which examined AAERs from 1987 to 1997. Using an

institutional theory framework it was hypothesized that the post-Enron environment may

have brought about changes in the activities of the SEC in an effort for this agency to

legitimize itself before major stakeholders. Our study did find evidence of changes when

compared to the COSO Report (1999). Specifically, we found that there far more AAERs

issued post-Enron and the companies involved were, on average, much larger, more

profitable and the frauds more substantial than those exhibited in the COSO Report

(1999). These findings hold even before considering the additional five high profile cases

that we added to accommodate the recommendation of Briloff (2001). Our results suggest

that the SEC became more aggressive at pursuing larger companies for financial

statement fraud in the post-Enron environment than perhaps was the case in the 1990s.

Our study has also addressed a major criticism of the COSO Report (1999) by

Briloff (2001) and O’Connell (2001), namely, that there were an insufficient number of

“high profile” companies included in the sample of the COSO Report (1999) . We believe

that the addition of case studies on five major accounting frauds to 55 randomly selected

cases addresses those criticisms of the COSO Report (1999).

There are several important implications of this research. First, while the COSO

Report (1999: 5) concluded companies committing financial statement fraud tend to be

small this certainly does not appear to be the case based on our more recent sample. In

fact, it would seem that accounting frauds often involve large companies with the most

senior executives implicated. These frauds often cross several reporting periods. A

26

second key implication is that, rather than being motivated to hide losses, the frauds

appear to be a mechanism for boosting reported earnings to appease Wall Street analysts.

The motivation for this appears to be ensuring a rising stock price and thus increased

executive remuneration. This evidence from the AAERs would seem to show that devices

designed to reduce agency costs such as stock options have provided a perverse incentive

for some executives to do whatever it takes, including fraud, to boost the stock price in

the short-term. A third implication is that improper revenue recognition through

recording fictitious revenues or recording revenues prematurely continues to be the

preferred methods for deception. Auditors and analysts alike need to remain vigilant in

searching for any signs of such reprehensible actions by management.

There are some limitations to the present study that should be recognized. First,

AAERs tend to be uneven in their level of disclosure and format thus making some more

useful for analysis purposes than others. It is apparent from both the COSO Report

(1999), and the present study, that to enhance the usefulness of AAERs for analysis

purposes, the SEC needs to improve their comparability in relation to language, structure

and content. Second, there is a possibility of selection bias by relying on AAERs as the

primary data source for financial statement fraud. This is because AAERs may reflect the

prevailing agenda of the SEC (Bonner et al., 1998) or differ in their nature or severity

(Feroz et al., 1991). Notwithstanding these limitations AAERs have been widely applied

by researchers as a reasonably objective and reliable data source for studying fraud (see,

for example, De Fond & Smith, 1991; Bonner, Palmrose, & Young, 1998). Third, the

observed rise in enforcement actions and the size of firms prosecuted may be explained

by a variety of factors other than legitimization such as a greater awareness of the

27

possibility of fraud post-Enron. Fourth, if one accepts that the COSO Report (1999)

possessed weaknesses in its sampling approach then it may not be an accurate source of

comparison for studying changes in the SEC’s enforcement activities over the period.

Avenues for future research include more case-based research into financial

statement fraud using a variety of sources such as company documents, court cases,

judgments and interviews. It would also be useful to conduct interviews with surveillance

personnel of the SEC to ascertain information about prevailing SEC agendas and

processes and their specific impact on AAERs.

28

APPENDIX ONESUMMARY OF THE ACCOUNTING AND AUDITING ENFORCEMENT

RELEASES (AAERs) n=55 INCLUDED IN THE SAMPLEAAER No.

Date Issued

Company name Fraud Technique Fraud Amount

Fraud Period

Executives Involved

1489 02.01.02 InaCom Corp Inflating income by various methods

$30.9m 1999 CFO, Asst Controller

1503 05.02.02 Critical Path Inc Backdating sales transactions

$21.7m 2000 President & Vice President

1509 01.03.02 Eagle Building Techniques Inc

False sales figures $10.6m 2001 CEO

1514 06.03.02 Freedom Surf Inc Fraudulently valuing assets

$5.1m 2000 President, Vice-President

1517 12.03.02 Gunther International Ltd

Overstatment of assets & Revenues, understatement of Expenses

$2.16m 1997-1998

CFO

1534 27.03.02 Signal Technology Corp

Understatement of losses

$2m approx

1997-1998

CEO, CFO, CTO

1543 22.04.02 Teltran Intn’l Group Overstatement revenues & earnings

$1.4m approx

1999 CEO

1596 05.06.02 Physician Computer Network Inc

Understating exp, inflating revenues

$57.3m 1996-1997

COO, CFO, Dir of Acctg

1577 14.06.02 Cylink Corporation Improperly recognizing revenue

$10.8m 1997-1998

CFO

1520 20.08.02 Centennial Technologies Inc

Overstatement of fixed assets, revenues, inventory

$40m 1994-1995

CEO, CFO

1623 04.09.02 Sunbeam Corporation

Channel Stuffing et al

$93m 1996-1998

CEO, CFO

1628 18.09.02 Sabratek Corp Overstatement of sales

$18.3m 1998-1999

CEO,CFO,CAO

1632 25.09.02 Dynegy Overstating net income

$474m 2001-2002

CFO

1638 01.10.02 Interspeed Inc Fraudulent Revenue Recognition

$9m 2000 CFO, V-President

1637A 25.11.02 Peregrine Systems Inc

Inflating income by various methods

$259m 1999-2003

CEO,CFO, et al

1691 16.12.02 Mercator Software Inc

Understatement of expenses

$2.4m 2000 CFO, Controller

1734 07.03.03 Hexagon Consolidated (HCCA)

Fraudulent recognition of assets

$368.6m 1996 CFO

1741 17.03.06 Anicom Inc Fictitious Sales $80m 1998-2000

CEO,CFO,COO

1735 10.03.03 American Tissue Inc Inflate revenues assets & profits

$49.9m 2000-2001

CEO,V-P Finance

29

AAER No.

Date Issued

Company name Fraud Technique Fraud Amount

Fraud Period

Executives Involved

1763 24.04.03 Chancellor Corporation

Inflate revenues assets & profits

$3.3m 1998 CEO,CFO,COO,CAO

1767 30.04.03 Candie’s Inc Record revenue prematurely

$4.4m 1997-1999

CEO,COO,CFO

1783 15.05.03 Just for Feet Inc Overstating existing assets. Overstating revenue

$8.3m 1997-1999

VP

1793 04.06.03 Madera International Inc

Inflated asset values

$0.68m 1999 CEO

1796 05.06.03 Xerox Corporation Record revenue prematurely

$3billion 1997-2000

CEO,CFO,COO,Controller

1813 14.07.03 Carnegie Intnl Corp Fraud. Reporting revenue & income

$8.64m 1998-2000

CEO,CFO,Sec, Director

1849 25.08.03 Solucorp Industries Lts

Recorded fictitious revenue

$354m 1997 CFO, VPs

1854 11.09.03 Brightpoint Inc Overstating income

$15m 1998-2000

CFO, Director

1862 11.09.03 Cais Internet Inc Record revenues prematurely

$1m 2000 VP Business Dev

1864 18.09.03 Homestore Inc Recog. Own cash as revenue

$119m 2000-2002

CEO,CFO, Various

1886 02.10.03 Analytical Surveys inc

Inflated revenue earnings

$6.5m 1999 CEO,COO,Controller

1912 14.11.03 Gateway Inc Record revenue prematurely

$154m 2000 CEO,CFO,Controller

1915 17.11.03 Schick Technologies Inc

Record revenue prematurely

$9.01m 1998-1999

CEO, VP Sales marketing

1928 18.12.03 Hanover Compressor Company

Record fictitious revenue

$17.5m 2000-2001

CEO,COO,CFO

1958 17.02.04 Performance Food Group Company

Overstate income fraudulently

$3.8m 2000-2001

Manager of Subsidiary

1963 25.02.04 ClearOne Communications Inc

Inflating revenues $21.2m 2001-2002

CEO,CFO

1975 11.03.04 Conseco Finance Corp

Overstating existing assets

$929.6m 1999-2000

CFO, CAO

1981 31.03.04 McKesson HBOC Premature Recog income

$20m 1999 CFO

1985 01.04.04 Powerball International Inc

Altered bank statements

$0.05m 2002-2003

Pres-Director

1993 27.04.04 Professional Transportation Group

Inflate income recording another entities sales

$3.1m 2000 Controller

1998 30.04.04 Quadramed Corporation

Record fictitious revenue

$5m 1998-1999

CFO

2035 14.06.04 Master Graphics Inc Fraud overstating net income

$0.63m 1999 CEO,CFO

2050 08.07.04 Measurement Specialities Inc

Capitalising Expenses (inventory)

$7.76m 2000-2001

CFO

2053 09.07.04 Sport-Haley Inc Overstated WIP $1.2m 1999 External Auditors

30

inventoryAAER No.

Date Issued

Company name Fraud Technique Fraud Amount

Fraud Period

Executives Involved

2109 24.09.04 Electro Scientific Industries

Overstated income, understated expenses

$6.9m 2002 CEO,CFO,Controller,Gen Counsel

2133 10.11.04 Computer Associates Int

Back-dating contracts to inflate revenues

$400m 2001-2005

General Counsel

2167 13.01.05 Royal Ahold/US Foodservice

Inflating income letters to auditors

$700m 2001-2002

Various

2194 02.03.05 Advanced Marketing Service

Overstate pre-tax earnings

$9.2m 2001-2003

A-P Advertising, Dir Adv.

2199 04.03.05 TALX Corporation Capitalizing Expenses

$4.1m 2001 CEO,CFO

2218 24.03.05 IGO Corporation Improperly recording revenue

$2.9m 1999-2000

CEO,CFO,COO

2222 04.04.05 Aurora Foods Under reported trading expenses

$43m 1998-1999

CEO,CFO,COO,Exec V-P

2223 06.04.05 Team Communication Group

Fraudulent circular sales contracts

$21.9m 1999-2001

CEO

2251 02.06.05 Huntington Bancshares inc

Fraudulent misstatements inc & Exp

$25.6m 2001-2002

CEO,CFO, Controller

2321 29.09.05 The Penn Traffic Company

Overstatement of income

$11m 1999-2002

Director of Subsidiary

2345 16.11.05 Patterson-UTI Energy

Embezzlement by CFO

$77.5m 2001-2005

CFO

2351 30.11.05 Friedman’s Inc Premature recog expense discounts

$3m 2001-2003

Senior Executives

31

Appendix TwoSummary of the Facts Alleged in AAERS of Five Major

Financial Statement Frauds during the Study Period

1. Waste Management Inc.

Sources: AAER Numbers 1405 to 1410 (all issued June 19, 2001); AAER No 2116

issued September 30, 2004.

Waste Management Inc provided comprehensive solid and hazardous waste

services, energy recovery services, and environmental technologies, engineering and

consulting services. The SEC found that the company’s financial statements were not

presented fairly, in all material respects, in conformity with GAAP for 1993 through 1996

and that the company’s auditors, Arthur Andersen, issued materially false and misleading

audit reports (AAER 1405). The audit firm was “censured”. The four Andersen partners

were banned from practice for a number of years and all but one subjected to a monetary

penalty (AAER No. 1410).

In addition, the SEC charged the founder and five other senior executives of

Waste Management with perpetrating a massive financial fraud lasting more than five

years. The Commission alleged that, beginning in 1992 and continuing into 1997,

defendants engaged in a systematic scheme to falsify and misrepresent the Company’s

financial results. The officers involved included the CEO, COO, CFO, CAO, the General

Counsel and Vice President of Finance (AAER No 2116).

32

Appendix Two (cont.)

To summarize the charges of improper accounting practices, the defendants

“resorted to improperly eliminating and deferring current period expenses to inflate

earnings.” Such practices included: avoiding depreciation expenses on their garbage

trucks; assigning arbitrary salvage values to other assets that previously had no salvage

value; failing to record expenses for decreases in the value of landfills as they were filled

with waste; refusing to record expenses necessary to write off the costs of unsuccessful

and abandoned landfill development projects; establishing inflated environmental

reserves (liabilities) in connection with acquisitions so that the excess reserves could be

used to avoid recording unrelated operating expenses; improperly capitalizing a variety of

expenses; and, failing to establish sufficient reserves (liabilities) to pay for income taxes

and other expenses (AAER No 2116) .

33

Appendix Two (cont.)

2. Qwest Communications International Inc (Qwest)

Source: AAER No 1726 issued February 25, 2003; AAER No 2209 issued on

March 15, 2005.

Qwest is a telecommunications and internet services company with corporate

headquarters in Denver, Colorado. Qwest was promoted to investors and market analysts

as a modern, progressive, new age technology company. Senior executives of the

Company, including the CEO, CFO and COO, promoted its EBITDA (Earnings Before

Interest, Taxation, Depreciation and Amortization) figures and set aggressive earnings

and growth targets. The SEC Complaint (AAER No 2209) states that “the business unit

executives made it clear that subordinates had to meet or exceed these aggressive

earnings targets at all costs” (p.17). The AAER also alleges that it was made clear to all

employees that falling short of the revenue projections was totally unacceptable and

could lead to dismissal. Over the next three years there were serious violations of

Generally Accepted Accounting Principles (GAAP) created to assist meeting analysts

expectations.

The SEC’s complaint was that the CEO, CFO, COO and many other senior

executives, committed fraud and other violations of the federal security laws. The

Commission alleged that the defendants engaged in a multi-faceted fraudulent scheme

designed to mislead the investing public about the Company’s revenue and growth. The

main charges claimed that the Company fraudulently recognized revenue from non-

recurring revenue sources over a period of three years from 1999 to 2002.

34

Appendix Two (cont.)

In 2003, the SEC filed civil fraud charges against eight officers and former

officers of Qwest associate Company global business and its markets. The complaint was

that these eight officers artificially accelerated Qwest’s recognition of revenue in two

equipment sale transactions for its Global Business Markets Unit (AAER No 1726). It is

alleged that that when the Qwest financial management indicated the company would

miss its quarterly targets, the Global Business Markets officers would bridge the gap by

fraudulently mischaracterizing these transactions. The cumulative amount of fraud for the

three years from 1999 to 2002 was $3.5 billion.

35

Appendix Two (cont.)

3. Tyco International Ltd (Tyco)

Source: AAER No 1839 issued on August 13, 2003.

Tyco is a diversified manufacturing and service company that has business

segments in fire and security services, electronics, healthcare and specialty products and

undersea telecommunications networks. It operates in 100 countries. The AAER stated

that “this is a looting case” and “it involves egregious, self-serving and clandestine

misconduct by the three most senior executives at Tyco.” The misconduct and violations

covered from at least 1996 until June 2002. It is suspected that investors were misled by a

pattern of improper and illegal activity by former management that included unauthorized

payments to dozens of Tyco employees at various levels. In short, the CEO and CFO

accepted hundreds of millions of dollars in secret, unauthorized and improper low interest

or interest-free loans and compensation from Tyco. Moreover, these payments were

concealed from shareholders. The federal security laws required disclosure of executive

loans, compensation and related party transactions. By failing to disclose these matters, it

is claimed that the CEO and CFO violated the antifraud provisions of the federal security

laws.

The engagement audit partner from Price Waterhouse Coopers for Tyco was

banned from practicing as an accountant. The CEO and CFO of Tyco were found guilty

of stealing $567 million from the company and both received jail terms of 25 years.

36

Appendix Two (cont.)

4. HealthSouth Corporation

Source: AAER no 1744 issued on March 20, 2003.

HealthSouth Corporation is America’s largest provider of outpatient surgery,

diagnostic and rehabilitative healthcare services. It owns or operates over 1800 different

facilities throughout the USA and abroad (SEC Complaint, 2003).

The CEO of HealthSouth orchestrated a scheme to artificially inflate reported

earnings to match stock analysts’ expectations so as to maintain the stock price. Between

1999 and the second quarter of 2002, HRC intentionally overstated its earnings by at least

$1.4 billion.

The following table shows the approximate amounts of overstated “Income

Before Income Taxes and Minority Interests since 1999” (AAER No. 1744). The total

misstated amount in the table is $1.4 billion.

Income (Loss)in $millions

1999Form 10-K

2000Form 10-K

2001Form 10-K

6 mths ended June 30, 2002

Actual $(191) $194 $9 $157Reported 230 559 434 340Misstated Amount 421 365 425 183Misstated Percentage 220% 188% 4.722% 119%

The AAER states that the senior officers of the Company would, on a quarterly

basis present the CEO with an analysis of the company’s actual but, as yet, unreported

earnings for the quarter as compared to Wall Street’s expected earnings for the Company.

If the actual financial results of HealthSouth fell short of analyst expectations, the CEO

would tell his executives to “fix it” by recording false earnings on HRC’s accounting

37

records to make up the shortfall. The AAER states that senior accounting personnel

would then convene a meeting to remedy the earnings shortfall.

Appendix Two (cont.)The entries designed to perpetrate the fraud primarily consisted of reducing a

contra revenue account called “contractual adjustment” and/or decreasing expenses

(either of which increased earnings) and correspondingly increasing assets or decreasing

liabilities (AAER no 1744). The CEO, Richard Scrushy, was indicted on 85 charges but,

in 2005, was acquitted on all counts of conspiracy and fraud. He has been further indicted

of bribery and fraud and found guilty in 2006.

5. Adelphia Communications Corporation

Source: AAER No 1599 issued on July 24, 2002.

Adelphia is the sixth largest cable television provider in the United States. The

Adelphia fraud is a case where a group of insiders (in this case, the Rigas family)

defrauded their company by exploiting a lack of internal controls. It was alleged that the

Rigas family manipulated financial records at Adelphia and, to hide the mounting debts

of the company, engaged in the creation of sham transactions and spurious companies.

The SEC charged that Adelphia, at the direction of the individual defendants: (1)

fraudulently excluded billions of dollars in liabilities from its consolidated financial

statements by hiding them in off-balance sheet affiliates; (2) falsified operations statistics

and inflated Adelphia’s earnings to meet Wall Street’s expectations; and (3) concealed

rampant self-dealing by the Rigas Family, including the undisclosed use of corporate

funds for Rigas family stock purchases and the acquisition of luxury condominiums in

New York and elsewhere (AAER No 1599). In subsequent litigation, John and Timothy

38

Rigas (father and son) were found guilty of conspiracy, bank fraud and securities fraud

and sentenced to 15 years in prison.

39

Table 1: AAER Sample Selection Process for Present Investigation Versus COSO Report (1999)

COSO Report (1999)(as cited in O’Connell, 2001: 170)

Present Study

40

Approximately 800 AAERs issued in periods 1987-97

300 firms involved in “Financial Statement Fraud”

220 Cases “randomly selected” from 300 firms

204 cases remain after 16 more cases are removed “due to data limitations”

99 cases only where researchers were able to obtain “last clean financial statement”

Approximately 870 AAERs issued in period 2002-2005

Total cases in study 60

5 “High Profile” cases selected and added to study

55 Cases randomly selected” from 330 items and used in the study

Approx 330 firms involved in “Financial Statement” Fraud

Table 2: Total Assets and Revenue for Sample Firms in the COSO Report (1999) and the Present Study

Total Assets(in $ 000’s)

% Change

Total Revenue(in $ 000’s)

% Change

COSO Report (1999)

This Study COSO Report (1999)

This Study

n=99 n=55 n=99 n=55Mean $532,766 $3,314,857 522.2 $232,727 $3,098,824 1,231.5Median $15,681 $186,951 1,092.2 $13,043 $62,580 379.8Min. Value

0* $588 0* 0*

1st Quartile

$2,598 $22,849 779.5 $1,567 $14,841 847.1

3rd Quartile

$73,879 $567,925 668.7 $54,442 $822,439 1,410.7

Max. Value

$17,880,000 $43,599,900 $11,090,000 $48,557,718

Note: Figures were taken from the last financial statement prior to fraud.

*Minimum values of zero reflect companies that were in development phases and hence had no revenue or assets in the period prior to the fraud.

Table 3: Net Income for Sample Firms in the COSO Report (1999) and the Present Study

Net Income / Loss (in $ 000’s) % Change

COSO Report (1999)

This Study

n=99 n=55Mean $8,573 $48,274 463.1Median $175 $1,802 929.7Minimum Value

($37,286) ($879,555)

1st Quartile ($448) ($1,678) 274.63rd Quartile $2,164 $45,678 2,010.1Maximum Value

$329,000 $1,206,000

Note: Figures were taken from the last financial statement prior to fraud.

41

Table 4: Stockholders’ Equity (Deficit) for Sample Firms in the COSO Report (1999) and the Present Study

Stockholders’ Equity (Deficit)(in $ 000’s)

% Change

COSO Report (1999)

This Study

n=99 n=55Mean $86,107 $735,084 753.7Median $5,012 $58,237 1,062.0Minimum Value

($4,516) ($467,706)

1st Quartile $1,236 $7,838 534.13rd Quartile $17,037 $230,030 1,250.2Maximum Value

$2,772,000 $12,785,239

Note: Figures were taken from the last financial statement prior to fraud.

Table 5: Types and Frequencies of Individual Executive Positions Named in AAERs for Sample Firms in the COSO

Report (1999) and the Present Study

Types and Frequencies of Individuals NamedCOSO Report (1999) This Study# of

Companies% of Fraud

Cases# of

Companies% of

Fraud Cases

Chief Executive Officer (CEO)

141 72% 26 47%

Chief Financial Officer (CFO)

84 43% 33 60%

Controller 41 21% 7 13%Chief Operating Officer (COO)

13 7% 9 16%

Chief Accounting Officer (CAO)

0 0% 3 5%

Other Vice President Positions

35 18% 11 20%

Board of Directors 21 11% 6 11%Lower Level Personnel 19 10% 1 2%Outsiders (eg Auditors, Customers)

74 38% 1 2%

No Title Given 30 15% 1 2%Other Titles 24 12% 6 11%

42

Table 6: Cumulative Fraud Amount for Sample Firms in the COSO Report (1999) and the Present Study

Cumulative Fraud Amount(in $ 000’s)

% Change

COSO Report (1999)

This Study

n=99 n=55Mean $25.0 $137.0 448.0Median $4.1 $10.8 163.41st Quartile $1.6 million $3.95 million 146.93rd Quartile $11.76 million $53.6 million 355.8Smallest Fraud $20 $50 150Largest Fraud $910,000 $3,000,000 229.7Note: Figures were taken from AAERs.

Table 7: Number of Financial Periods (Years) Covered by Fraud for Sample Firms in the Present Study

Financial Periods (Years) Covered by Fraud Number of Sample

% of Total Sample

One Year 20 36Two Years 20 36Three Years 10 18Four Years 2 4Five Years 3 6Note: Figures were taken from AAERs. n=55 companies. The COSO Report (1999) did not provide data on this variable broken down as above. However, The COSO Report (1999) reported that 14% of the frauds were for one year or less with an average period of approximately two years (p.30).

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Table 8: Common Financial Statement Fraud Techniques used by Sample Firms in the COSO Report (1999) and the Present

Study

COSO Report (1999) Present StudyMethods Used to Misstate

Financial StatementsPercentage of Sample Using Fraud Method

Percentage of Sample Using Fraud Method

Sub-Category

Overall category

Sub-Category

Overall category

Improper Revenue Recognition 50% 96%- Recording Fictitious Revenues 26% 36%- Recording Revenues Prematurely

24% 36%

- No description/overstated 16% 23%

Overstatement of Assets (excluding accounts receivable overstatements due to revenue fraud)

50% 53%

- Overstating Existing Assets 37% 35%- Recording fictitious Assets or Assets not owned

12% 7%

- Capitalizing items that should be expenses

6% 11%

Understatement of Expenses/Liabilities

18% 24%

Misappropriation of Assets andOther Miscellaneous Techniques

40% 11%

Note: Figures were taken from AAERs. COSO Report (1999) n =204; Present Study n = 55.

Subcategories such as “Recording Fictitious Revenues” and “Capitalizing Expenses” do not sum to the overall category totals due to multiple types of fraud involved at a single company. So, for example, a company could have recorded revenues both fictitiously and recorded prematurely.

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Table 9: Summary of Key Characteristics of Five Major Frauds during the Study PeriodCompany Size Profitability S/holders

EquityExecutives Implicated

Acc. Amount of Fraud

Length of Fraud

Fraud Technique Used

Total Assets $’million

Total Revenue$’million

Net Income/ Loss$’million $’million $’million

Waste Management

769.09 270.03 (2.26) 239.4 CEO, CFO, COO, CAOGeneral CounselVP – Finance

1,700 5 years Inflating earnings by deferring and capitalizing expenses.

Qwest Management

8,060 2,242 (849.8) 4,238 CEO, CFO, COO

3,500 4 years Accelerated recognition of revenue.

Tyco International

5,900 6,597 687.9 3,050 CFO, CEO 567 7 years plus

Concealing from shareholders that unauthorized loans were made to CEO and CFO. Theft from company.

HealthSouth Corp.

6,770 4,000 46.5 3,420 CEO 1,400 7.5 years plus

Overstating earnings by boosting revenue/ reducing expenses.

Adelphia Communications

1,640 472.7 (119.2) (1,250) CEO, CFO, VP-Finance, Directors

2,300 4 years Hiding of liabilities off-balance sheet, inflating earnings. theft of company funds.

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